RIZAL TECHNOLOGICAL UNIVERSITY

Cities of Mandaluyong and Pasig

LESSON 1

INVENTORIES

1. Nature, Classes and Transactions about Inventories

2. Accounting for Inventories
3. Inventory Cost Flow
4. Lower of Cost and Net Realizable Value
5. Inventory Estimation Methods

Overview

This module is prepared for the students to understand the nature of

inventories.
This module introduces the nature of inventories, types and classification,
initial recognition and measurement, subsequent measurement and reclassification,
derecognition and presentation in the financial statements.
This module will cover a brief discussion of the theory and standard behind
the topic, exercises and practice problem the cover the said topic.

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 RIZAL TECHNOLOGICAL UNIVERSITY
Cities of Mandaluyong and Pasig

Study Guide

This module is designed for the students to understand inventories. This module
includes:
1. Topic Discussions - to be read by the students to fully understand the topic.
2. Assessment – to be accomplished by the students after the discussion to test
their skills and understanding to the subject matter.
3. Assignment – activity to be done by students to be submitted to the instructor.
This is to reinforce or advance the student’s learning. It is relevant to the past,
current, and future lessons.
To complete the requirements of this module, the students are required to:
1. Read and understand the topic discussion and the guided exercises
2. Accomplish the assessment.
3. Accomplish the assignment due on next meeting.

Learning Outcomes

At the end of the discussion, the students are expected to:

1. Describe and understand the nature of inventories and identify the items to be
included in the account title “Inventories”.
2. Describe the initial recognition and measurement, subsequent recognition and
measurement, derecognition and financial statements presentation of inventories
3. Identify, compare and contrast inventory accounting systems – periodic and
perpetual system
4. Compare and contrast different kinds of inventory cost flow
5. Calculate the cost of inventory using inventory estimation.

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 RIZAL TECHNOLOGICAL UNIVERSITY
Cities of Mandaluyong and Pasig

Topic Presentation

NATURE OF INVENTORIES
Inventories, under PAS 2, are assets which are:
a. held for sale in the ordinary course of business;
b. in the process of production for such a sale; or
c. in the form of materials or supplies to be consumed in the production process or in
the rendering of services.
Inventories encompass goods purchased by a retailer and held for resale such as merchandise
purchased by a retailer and held for resale. These can be classified as inventories of a trading
concern. A trading concern is one that buys and sells goods in the same form purchased.
Inventories also encompass finished goods produced by the entity, goods in process and
materials and supplies awaiting use in the production process. These can be classified as
inventories of a manufacturing 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 – are completed products which are ready for sale.
b. Goods in process or work in process – are partially completed products which require
further process or work before they can be sold.
c. Raw materials – are goods that are to be used in the production process. Raw materials
can be directly attributed to the product (direct materials) or indirectly attributed to the
product (indirect materials such factory or manufacturing supplies).
Inventories can also be properties such as land, building, machineries with the primary intention
to resell such properties to customers.

INVENTORY INCLUSIONS AND EXCLUSIONS

As a rule, all goods to which the entity has title shall be included in the inventory, regardless of
location.

a. Goods owned and on hand

b. Goods in transit and sold FOB destination
Under FOB destination, ownership of goods purchased is transferred only upon receipt of
the goods by the buyer at the point of destination. Thus, Thus, sold goods in transit under
FOB Destination must be still included in the inventories.

The seller is responsible for the delivery charges. Thus, such cost will be considered as
freight out under selling expenses and will become part of operating expenses.
c. Goods in transit and purchased FOB shipping point
Under FOB shipping point, ownership of goods purchased is transferred upon shipment of
goods to the buyer. Thus, purchased goods in transit under FOB shipping point must be
included in the inventories.

The buyer is responsible for the delivery charges. Hence, such cost will be considered as
freight in and will become part of the initial cost of the inventory.

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 RIZAL TECHNOLOGICAL UNIVERSITY
Cities of Mandaluyong and Pasig

Terms related to Freight Charge

Figure 1. FOB Destination and FOB Shipping Point Arrangement

▪ FOB Destination
It means that ownership of the goods purchased is vested in the buyer upon receipt
thereof. The seller shall be responsible for the freight charge up to the point of
destination.
▪ FOB Shipping Point (“res perit domino” → buyer bears the risk)
It means that ownership of the goods purchased is vested in buyer upon shipment
thereof. The buyer will pay the transportation charge from the point of shipment to the
point of destination. This arrangement can be assumed if the agreement is silent.
▪ Freight Collect
It means that freight charge on the goods shipped is not yet paid. The common carrier
shall collect the same from the buyer. The freight charge is actually paid by the buyer.
▪ Freight Prepaid
It means that freight charge on the goods shipped is already paid by the seller.
▪ Free alongside (FAS)
Seller bears all risks and expenses upon delivery of goods to the dock/alongside the
vessel of shipment. The expense of loading and shipping is borne by the buyer, and the
title passes to him/her when the carrier takes possession.
In essence, this maritime shipping term is similar to FOB Shipping Point.
▪ Cost, Insurance and Freight (CIF)
The buyer agrees in the shipping contract to pay the cost, insurance and freight in a
lump sum. The seller is responsible to for the cost of loading. As a result, title and risk
of loss pass to the buyer when the items are delivered to the carrier.
In essence, this maritime shipping term is similar to FOB Shipping Point.
▪ Ex-ship
Seller bears all risks and expenses until the goods are unloaded and in which title &
risks shall pass to the buyer.
In essence, this maritime shipping term is similar to FOB Destination.

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 RIZAL TECHNOLOGICAL UNIVERSITY
Cities of Mandaluyong and Pasig

d. Goods out on consignment

Consignment is a method of marketing goods in which the owner (consignor) transfers
physical possession of certain goods to an agent (consignee) who sells them on the owner’s
behalf.
Consigned goods, including freight and other handling charges 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 cost of goods consigned.

“Goods out on consignment” account is ordinarily associated with consignor, thus, the
amount related to the said account will form part of its inventories.

“Goods held on consignment” account is ordinarily associated with consignee, thus, the
amount related to the said account will not form part of its inventories.
e. Goods held by customers on approval or on trial
Inventories are recorded in an entity’s books if the title to the goods is still in their
possession. If items are provided to a customer for approval or trial, ownership remains
with the seller, even if the customer has the physical possession of them, because the buyer
can still reject or return items to the vendor, the risk remains with the seller, and the seller
retains ownership.
Goods sent on approval to a potential buyer should remain as inventory on the seller until
payment is received for items kept by the buyer.
f. Sale but buyer given the right to return
The revenue from the sales transaction shall be recognized at of sale only if all the following
conditions are met:
✓ The seller’s price to the buyer is substantially fixed or determinable at the date of sale;
✓ The buyer has paid the seller, or the buyer is obligated to pay the seller and the
obligation is not contingent on resale of the product;
✓ The buyer’s obligation to the seller would not be changed in the event of theft or physical
destruction or damage of the product;
✓ The buyer acquiring the product for resale has economic substance apart from that
provided by the seller;
✓ The seller does not have significant obligations for future performance to directly about
the resale of the product by the buyer; and
✓ The amount of future returns can be reasonably estimated.
If the above conditions are not met, the seller should continue to recognize the inventory.
g. Sale with a buyback agreement/Product Financing/Park Sale
A buyback arrangement is a form of product financing arrangement. The seller transfers its
inventory in the buyer’s premises thru sales contract that clearly specifies to purchase back
the same inventory over a specified period of time at a specified amount.
The inventory in this kind of arrangement is included in the inventory of the seller.
h. Installment sales
Installment contracts may provide for retention of title by the seller until the selling price is
fully collected. The goods sold on installment basis are still the property of the seller and
therefore normally includible in the inventory.

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 RIZAL TECHNOLOGICAL UNIVERSITY
Cities of Mandaluyong and Pasig

However, in such a case, it is an acceptable accounting procedure to record the installment

sale as regular sale involving deferred income as 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.
i. Segregated Goods
Special order goods manufactured according to customer specifications should be
considered sold when completed, even if it is still in the possession of the seller.
Mere segregation does not exclude the inventory, however, if the segregation is due to
sales contract such as special order, such inventory is excluded in the inventory of the
seller.
Goods that are customarily manufactured and constitute stock items of the entity even if
physically segregated, are still included in the inventory of the seller until it is delivered to
the customer.
j. Bill-and-hold Sales
A bill-and-hold arrangement is 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.
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);
✓ The goods ae identified separately as belonging to the customer;
✓ The goods are available for immediate transfer to the customer; and
✓ The seller cannot use the goods or sell them to another customer.

k. Goods sold under Lay-away Plan

Under a lay-away plan, payments are made by the customer on installment basis but the
goods remain in the possession of the seller. When full payment is received, the goods are
physically delivered to the customer.
Under this scheme, the seller continues to include the hoods in its inventory until actually
delivered.
The cash collected are advances from customers and therefore, reported as liability.

l. Inventories in hands of a sales agency

Sales agency pertains to the marketing arm of an entity. It could be a small team whose
function is to market the products or services provided by an entity and any potential sales
should be approved first by the entity before it becomes an official sales transaction.

The entity that owns the sales agency is also entitled to the ownership of the inventories
held by the said sales agency.

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 RIZAL TECHNOLOGICAL UNIVERSITY
Cities of Mandaluyong and Pasig

Illustration 1: Correct Balance of Inventories

On December 31, 2022, YEAGER INC. provided the following information about inventories and
related accounts:
Direct materials in good condition 1,500,000
Advance for materials ordered 200,000
Goods in process 650,000
Unexpired insurance on inventories 60,000
Factory and production supplies 10,000
Advertising catalogs and shipping cartons 150,000
Finished goods in factory 2,000,000
Finished goods in company-owned retail store, including 40% profit on cost 750,000
Finished goods in hands of consignees, excluding 40% profit on sales 400,000
Finished goods in transit to customers, at cost, FOB destination 250,000
Finished goods out on approval, at cost 100,000
Unsalable finished goods, at cost 50,000
Office supplies 40,000
Materials in transit shipped FOB shipping point, including freight of 30,000 330,000
Goods held on consignment, at sales price, costing 150,000 200,000
During the count, YEAGER noted a packing case containing product costing P1,000,000 was
standing in the shipping area, marked “Hold for Shipping Instructions.” The customer’s order
was dated December 18, 2022 but the case was shipped, and the customer billed on January
10, 2023.
Required: What is the correct amount of inventory to be reported on December 31, 2022?

Direct materials in good condition 1,500,000

Goods in process 650,000
Factory and production supplies 10,000
Finished goods in factory 2,000,000
Finished goods in company-owned retail store, including 40% profit on cost
(750,000 ÷ 150%) 535,714
Finished goods in hands of consignees, excluding 40% profit on sales 400,000
Finished goods in transit to customers, at cost, FOB destination 250,000
Finished goods out on approval, at cost 100,000
Materials in transit shipped FOB shipping point, including freight of 30,000 330,000
Packing case tagged “Hold for shipping instructions” 1,000,000
Inventories to be reported on December 31, 2022 6,775,714

▪ Advances for materials ordered shall be classified as other current/noncurrent asset

depending on the term of the advances.
▪ Unexpired insurance on inventories and office supplies shall be classified as prepaid
expenses.
▪ Advertising catalogs and shipping cartons shall be classified as selling expenses.
▪ Unsalable finished goods shall not be included in the balance of inventories and shall be
written off.
▪ Goods held on consignment shall not be included in the inventory balance as these
inventories are controlled by the consignor, not by the consignee.

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 RIZAL TECHNOLOGICAL UNIVERSITY
Cities of Mandaluyong and Pasig

ACCOUNTING FOR INVENTORIES

INVENTORY ACCOUNTING SYSTEMS
In accounting for inventories, there are two systems used to account for inventory:
1. Periodic system – under this system, a physical counting of goods on hand at the end of
the accounting period is performed to determine the inventory quantities.
Characteristics:
▪ Normally used for relatively low value inventory items
▪ The inventory account is updated only when financial statements are prepared
▪ Physical count is performed to determine the ending balance of inventory and to
compare for the cost of goods sold.
▪ The system uses purchase-related accounts such as Purchases, Freight In, Purchase
Returns and Allowances, Purchase Discounts.
2. Perpetual system – under this system, a maintenance of records called stock cards that
usually offer a running summary of the inventory inflow and outflow is required.
Characteristics:
▪ Normally used for low-volume, high-cost items. Because of technology, perpetual
inventory system may be used also for low value inventory with the aid of point-of-sale
devices connected to company’s inventory system.
▪ The inventory account is updated for every purchase, sales, returns and discounts of
inventory.
▪ Physical count is performed to determine the accuracy of the balance per records
PROFORMA JOURNAL ENTRIES
Particulars Periodic System Perpetual System
1. Purchase of Purchases xxx Inventory xxx
merchandise Accounts Payable xxx Accounts Payable xxx
on account
2. Payment of Freight In xxx Inventory xxx
freight on Cash/Accounts Payable xxx Cash/Accounts Payable xxx
the purchase
3. Return of Accounts Payable xxx Accounts Payable xxx
merchandise Purchase Returns xxx Inventory xxx
purchased to
supplier
4. Sale of Accounts Receivable xxx Accounts Receivable xxx
merchandise Sales xxx Sales xxx
on account Cost of Sales xxx
Inventory xxx
5. Sale of Sales Returns xxx Sales Returns xxx
merchandise Accounts Receivable xxx Accounts Receivable xxx
on account Inventory xxx
Cost of Sales xxx
6. Adjustment Inventory, ending xxx Ending merchandise inventory is
of ending Income Summary xxx not adjusted. The balance of the
inventory merchandise inventory account
represents the ending inventory.

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 RIZAL TECHNOLOGICAL UNIVERSITY
Cities of Mandaluyong and Pasig

TRADE DISCOUNT AND CASH DISCOUNTS

Trade Discounts
Trade discounts, also known as volume or quantity discounts, are means of converting a catalog
price to the prices actually charged to the buyer. These may be used to make price differentials
among different classes of customers, varying quantities, or changes in prices. Such trade
discounts are also used to avoid frequent changes in prices. Such trade discounts are also used
to avoid frequent changes in catalogs and to hide the true invoice price from competitors. They
are commonly quoted in percentage, and at times, series of percentages.
Trade discounts are not recognized for financial accounting purposes. They are deducted from
the list prior to recording the accounts receivable arising from a credit sales transaction. To
state simply, both accounts receivable and the related revenue are always recorded net of trade
discounts.
Cash Discounts
Cash discounts, or sales discounts from the seller’s point of view, are reductions from the
sales price as an inducement for prompt payment of an account. They are expressed in terms
which may read as: 2/10, n/30 (2% discount is granted if account is paid within 1- days from
the invoice date, gross amount due in 30days); 3/15, n/60 (3% discount is granted if account is
paid within 15 days from the invoice date, gross amount due in 60 days).
The purchase transaction may be recorded using either the gross method or the net method
when the seller offered a cash discount for the early payment of the account

1. Gross method - when the entity uses the periodic inventory system, the Purchases account
and the Accounts Payable are recorded at the gross invoice price. A cash discount taken on
purchases is recorded upon payment as a credit to Purchase Discounts. Any balance of
Purchase Discounts is reported in profit or loss as a deduction from gross purchases.
When the entity uses the perpetual inventory system, the purchase transaction is recorded
in Inventory account and any cash discount taken is credited to Inventory account, if the
related goods are still unsold or to Cost of Goods Sold account, if the related goods are still
unsold or to Cost of Goods Sold account, if the related goods have already been sold.
2. Net method - when the entity adopts the periodic inventory system, both Purchases and
Accounts Payable are initially recorded at invoice price less the cash discounts available. A
cash discount not taken is recorded as Purchase Discounts Lost, which is, reported in profit
or loss as part of finance cost.

PROFORMA JOURNAL ENTRIES

Particulars Gross Method Net Method
1. Purchase of Purchases/Inventory xxx Purchases/Inventory xxx
merchandise Accounts Payable xxx Accounts Payable xxx
on account (at gross amount) (at net amount)
2. Payment Accounts Payable xxx Accounts Payable xxx
within Purchase Discounts xxx Cash xxx
discount Cash xxx
period
3. Payment Accounts Payable xxx Accounts Payable xxx
beyond Cash xxx Purchase Discount Lost xxx
discount Cash xxx
period

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 RIZAL TECHNOLOGICAL UNIVERSITY
Cities of Mandaluyong and Pasig

Inventory Shortages
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.

Inventory Shortage xxx

Inventory xxx
To record inventory shortage.

Inventory xxx
Inventory Overage xxx
To record inventory overage.

The inventory shortage is usually closed to cost of goods sold because it 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.

Illustration 2: Inventory Systems, Discounts and Shortages

ACKERMANN INC. is a distributor and wholesaler of carpets. During November 1, 2022,
ACKERMANN’s inventory consisted of 190 carpets priced at P1,000 each and the following
transactions occurred:

Nov. 2 Purchased 800 carpets on account at Php 1,000 each with terms 2/10, n/30.
5 Returned 50 defective carpets to supplier and received credit.
8 Paid all of the carpets purchased.
Dec. 1 Sold 790 carpets at Php 2,000 each
15 Received 20 carpets returned by a customer and gave credit. The goods were in
excellent condition.
16 Received cash for the carpets sold.
31 Physical count at year-end revealed 50 units on hand.
Required:
1. Prepare journal entries on the transactions above assuming ACKERMANN uses periodic and
perpetual inventory system.
2. Compute for the cost of goods sold under each inventory system.

Requirement 1. Journal Entries

Date Periodic System Perpetual System
2022
Nov. 2 Purchases 800,000 Inventory 800,000
Accounts Payable 800,000 Accounts Payable 800,000

5 Accounts Payable 50,000 Accounts Payable 800,000

Purchase Returns 50,000 Inventory 800,000

8 Accounts Payable 750,000 Accounts Payable 750,000

Purchase Discounts 15,000 Inventory 15,000
Cash 735,000 Cash 735,000

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 RIZAL TECHNOLOGICAL UNIVERSITY
Cities of Mandaluyong and Pasig

Date Periodic System Perpetual System

Dec. 1 Accounts Receivable 1,580,000 Accounts Receivable 1,580,000
Sales 1,580,000 Sales 1,580,000

Cost of Sales 790,000

Inventory 790,000

15 Sales Returns 40,000 Sales Returns 40,000

Accounts Receivable 40,000 Accounts Receivable 40,000

Inventory 20,000
Cost of Sales 20,000
16 Cash 1,540,000 Cash 1,540,000
Accounts Receivable 1,540,000 Accounts Receivable 1,540,000

31 Inventory, ending 50,000 Inventory Shortage 105,000

Income Summary 50,000 Inventory 105,000

[(170 units x P1,000) - 15,000] - (50

x P1,0000)
Generally, the inventory shall not be
adjusted, but because the actual count is
different from the monitored inventory
balance, an inventory shortage shall be
recognized by reducing the inventory
balance to its actual amount.

Requirement 2. Cost of Goods Sold

Periodic Inventory System

Inventory, beginning 190,000
Purchases 800,000
Purchase returns (50,000)
Purchase discount (15,000) 735,000
Total Goods Available for Sale 925,000
Inventory, ending (50,000)
Cost of goods sold 875,000

Perpetual Inventory System

Cost of goods sold recorded
(790,000 – 20,000) 770,000
Inventory shortage (105,000)
Cost of goods sold 875,000

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 RIZAL TECHNOLOGICAL UNIVERSITY
Cities of Mandaluyong and Pasig

INITIAL MEASUREMENT OF INVENTORIES

Inventories are initially measured at historical cost. The cost of inventories shall comprise:
a. Cost of purchase
The cost of purchase of inventories comprises the following:
1. Purchase price
2. Import duties and irrecoverable taxes
3. 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 in foreign currency.
Moreover, when inventories are purchased with deferred settlement terms, the
difference between purchase price for normal credit terms and the amount paid is
recognized as interest expense over the period of financing.
b. Cost of conversion
The cost of conversion of inventories includes cost directly related to the units of production
such as:
1. Direct labor
These are cost of wages and salaries directly attributed to the production of its goods
or services.
2. Variable production overheads
Indirect costs of production that vary directly, or nearly indirectly, with the volume of
production, such as indirect materials and indirect labor. Variable production overheads
are allocated to each unit of production based on the actual use of the production
facilities.
Examples are indirect labor and indirect materials.
3. Fixed production overheads
Indirect costs of production that remain relatively constant regardless of the volume
production. Variable production overheads are allocated to each unit of production
based on normal capacity of the production facilities.
Examples are depreciation of factory equipment and warehouse and costs of factory
management and administration.
c. Other cost incurred in bringing the inventories to their present location and condition
These are costs that are directly attributed to the cost of inventories, such as:
1. Borrowing costs
PAS 23 requires capitalizing interest on inventories which take a substantial amount of
time to create. However, an entity should not capitalize borrowing costs for inventories
that are manufactured in large quantities on repetitive basis.
2. Storage costs
This can be included for products that require a maturation process or substantial
amount of time to create.
3. Nonproduction overheads or costs of designing products for specific customer

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Cities of Mandaluyong and Pasig

The following are excluded from the cost of inventories:

a. Abnormal amounts of wasted materials, labor or other production costs
b. Storage costs, unless these costs are necessary in the production process prior to a further
production stage
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
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 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 which they are incurred.
Illustration 3: Initial Measurement of Inventories
LEONHART INC. is a manufacturing business. The cost of an inventory is shown on its stock
card as follows:

Direct material cost 450,000

Freight in 25,000
Freight out 50,000
VAT on importation 54,000
Import duties 25,000
Production labor cost 200,000
Factory overhead cost 50% of production labor cost
Storage cost on work-in-process inventories 50,000
Storage cost on finished goods inventories 100,000
After-sales warranty costs 50,000
Salaries of accountants 80,000
Other general administration cost 215,000
Marketing expenses 200,000
Required: What is the correct amount of inventory to be reported on the information above.
Direct material cost 450,000
Freight in 25,000
Import duties 25,000
Production labor cost 200,000
Factory overhead cost (200,000 x 50%) 100,000
Storage cost on work-in-process inventories 100,000
Correct value of inventory 900,000

▪ Freight out, storage cost on finished goods inventories, after-sales warranty costs, salaries
of accountants, other general administrative cost and marketing expenses shall be classified
as operating expenses.
▪ VAT on importation is not added to cost of inventories because these types of taxes are
recoverable and shall be classified as separate asset.

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Cities of Mandaluyong and Pasig

SUBSEQUENT MEASUREMENT AND LOWER OF COST AND NET REALIZABLE VALUE

Inventories shall be subsequently measured at the lower of cost and net realizable value
(LCNRV).
Net realizable value is the estimated selling price in the ordinary course of business less the
estimated cost of completion and the estimated cost of disposal.
Inventories are usually written down to realizable value on individual basis. However, in the
circumstance where items in the inventory relate to same product line, have similar purposes
and uses, and are produced and marketed in the same geographical area, the group of similar
items basis may be more appropriate. Whichever basis is used shall be consistently applied.
The cost of inventories may not be recoverable under the following circumstances:
a. The inventories are damaged.
b. The inventories have become wholly or partially obsolete.
c. The selling prices have declined.
d. The estimated cost of completion or the estimated cost of disposal has increased.
If the cost is lower than net realizable value, the inventory will be measured at cost and any
increase in value is not recognized.

If the net realizable value is lower than cost, the inventory will be measured at net realizable
value and the decrease in value is recognized as inventory write-down. In summary, the
determination of subsequent measurement of inventories are as follows:
1. Compute the net realizable value (NRV) per item of inventory. The NRV are computed as
follows:
a. Net realizable value of finished goods inventory:
Estimated selling price xxx
Less: Estimated cost to sell (xxx)
Less: Estimated cost to repair (if any) (xxx)
Net realizable value xxx
b. Net realizable value of work in process inventory:
Estimated selling price xxx
Less: Estimated cost to sell (xxx)
Less: Estimated cost to complete (xxx)
Net realizable value xxx

c. Net realizable value of raw materials inventory shall be equal to the replacement cost
of the raw materials inventory.
2. Compare the net realizable value and the cost of each item of inventory, select the lower.
3. Get all the lower amounts determined to compute for the carrying amount of the inventory.
The difference between the carrying amount computed and the unadjusted inventory are
recognized as loss on inventory writedown.
When an item of inventory has been written down to its net realizable value, and if in subsequent
balance sheet period of the same inventory still on hand, a new assessment of net realizable
value should be made.
If there is a clear evidence of an increase in net realizable value because of change in economic
condition the amount of write-down should be reversed. The amount of reversal should not
exceed the original amount of write-down that was recognized previously.

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 RIZAL TECHNOLOGICAL UNIVERSITY
Cities of Mandaluyong and Pasig

Methods of Accounting for the Inventory Writedown

a. Direct method or cost of goods sold method
The inventory is recorded at LCNRV. Any loss on inventory writedown or gain or reversal of
inventory write is not accounted for separately but included in the cost of goods sold.
Inventory, beginning (at LCNRV) xxx
Add: Net Purchases xxx
Total goods available for sale xxx
Less: Inventory, ending (at LCNRV) (xxx)
Cost of goods sold after inventory writedown xxx
Under this option, ending inventory is directly debited and the cost of sales is already
credited, thus, it is the amount that will appear on the face of the statement of financial
position. The journal entry is as follows (assuming periodic inventory system):
Inventory, ending xxx
Income Summary (at NRV) xxx
b. Allowance method or loss method
The inventory is recorded at cost and any loss in inventory writedown is accounted for
separately. A loss account (loss on inventory writedown) is debited and a valuation account
“allowance for inventory writedown” is credited.
Inventory, beginning (at cost) xxx
Add: Net Purchases xxx
Total goods available for sale xxx
Less: Inventory, ending (at cost) (xxx)
Cost of goods sold before inventory writedown xxx
Add: Loss on inventory writedown xxx
Less: Gain on reversal of inventory writedown (xxx)
Cost of goods sold after inventory writedown xxx
The gain or loss on inventory writedown may be computed as follows:
Inventory, ending (at cost) xxx
Less: inventory, ending (at LCNRV) (xxx)
Required allowance on inventory writedown xxx
Less: Allowance on inventory writedown, beginning (xxx)
Loss (gain) on inventory writedown xxx
In this option, the allowance for inventory writedown shall be deducted from the gross
amount of inventory. The journal entry is as follows (assuming periodic inventory system):
Inventory, ending xxx
Income Summary (at cost) xxx
Loss on Inventory Writedown xxx
Allowance for Inventory Writedown xxx
Loss on inventory writedown is included in cost of goods sold.
Any reversal of inventory writedown is deducted from the cost of goods sold and to be
recorded as:
Allowance for Inventory Writedown xxx
Gain on Reversal of Inventory Writedown xxx
However, the gain is limited only to the extent of the allowance balance.

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Illustration 4: Subsequent Measurement of Inventories

HOOVER COMPANY sells four kinds of merchandise. The inventory balance on January 1, 2022
amounted to P2,000,000 and net purchases for the current year amounted to P15,000,000. The
following per-unit data relate to these items on December 31, 2022:

Units Cost Sales price Selling cost Normal profit

Category 1:
ROYAL 5,000 105 130 15 20
MILITARY 20,000 85 90 10 10
Category 2:
GARRISON 40,000 40 45 10 5
SURVEY 80,000 60 75 25 10
Required:
A. Calculate the value of inventory under the following approaches:
1. The LCNRV is applied to the individual inventory item.
2. The LCNRV is applied to the inventory category.
3. The LCNRV is applied to the inventory as a whole.
B. Assuming the LCNRV is applied to the individual inventory item, compute for the loss on
inventory writedown.
C. Assuming the LCNRV is applied to the individual inventory item, compute for cost of goods
sold and prepare the necessary journal entries using:
1. Direct method
2. Allowance method
D. Continuing letter (C), subsequently, on December 31, 2023, the cost of inventories
amounted to P8,900,000, the total net realizable value of inventories amounted to
P8,700,000.
Requirement A.1: The LCNRV is applied to the individual inventory item.

Units Unit Cost NRV Total Cost NRV LCNRV

(a) (b) (c) (a x b) (a x c)
Category 1:
ROYAL 5,000 105 115 525,000 575,000 525,000
MILITARY 20,000 85 80 1,700,000 1,600,000 1,600,000
SUBTOTAL 2,225,000 2,175,000
Category 2:
GARRISON 40,000 40 35 1,600,000 1,400,000 1,400,000
SURVEY 80,000 60 50 4,800,000 4,000,000 4,000,000
SUBTOTAL 6,400,000 5,400,000
GRAND TOTAL 8,625,000 7,575,000 7,525,000
The inventory to be reported is P7,525,000.

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Requirement A.2: The LCNRV is applied to the inventory category.

Total Cost NRV LCNRV
Category 1 2,225,000 2,175,000 2,175,000
Category 2 6,400,000 5,400,000 5,400,000
Total 7,575,000
The inventory to be reported is P7,575,000.
Requirement A.3: The LCNRV is applied to the inventory as a whole.
Total Cost NRV LCNRV
TOTAL 8,625,000 7,575,000 7,575,000
The inventory to be reported is P7,575,000.
Requirement B: Loss on Inventory Writedown
Inventory, ending (at cost) 8,625,000
Less: inventory, ending (at LCNRV) (7,525,000)
Required allowance on inventory writedown 1,100,000
Less: Allowance on inventory writedown, beginning -
Loss on inventory writedown 1,100,000
Requirement C: Cost of Goods Sold and Journal Entries
Direct Method
Cost of Goods Sold Computation:
Inventory, beginning (at LCNRV) 2,000,000
Add: Net Purchases 15,000,000
Total goods available for sale 17,000,000
Less: Inventory, ending (at LCNRV) (7,525,000)
Cost of goods sold after inventory writedown 9,475,000
2022
Dec. 31 Inventory, ending 7,525,000
Income Summary 7,525,000
To record ending inventory at net realizable value.
The loss on inventory writedown of P1,100,000 is not accounted for separately.
Allowance Method
Cost of Goods Sold Computation:
Inventory, beginning (at cost) 2,000,000
Add: Net Purchases 15,000,000
Total goods available for sale 17,000,000
Less: Inventory, ending (at cost) (8,625,000)
Cost of goods sold before inventory writedown 8,375,000
Add: Loss on inventory writedown 1,100,000
Cost of goods sold after inventory writedown 9,475,000
2022
Dec. 31 Inventory, ending 8,625,000
Income Summary (at cost) 8,625,000
To record ending inventory at cost.

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Loss on Inventory Writedown 1,100,000

Allowance for Inventory Writedown 1,100,000
To recognize inventory writedown.

Requirement D: Gain on Reversal on Allowance for Inventory Writedown

Direct Method
Inventory, ending (at cost) 8,900,000
Less: inventory, ending (at LCNRV) (8,700,000)
Required allowance on inventory writedown 200,000
Less: Allowance on inventory writedown, beginning (1,100,000)
Gain on reversal of inventory writedown (900,000)

2023
Dec. 31 Inventory, ending 8,700,000
Income Summary 8,700,000
To record ending inventory at net realizable value.
The gain on reversal of inventory writedown of P900,000 is not also accounted for separately
using direct method.
Allowance Method
2023
Dec. 31 Inventory, ending 8,900,000
Income Summary 8,900,000
To record ending inventory at cost.
Allowance for Inventory Writedown 900,000
Gain on Reversal of Inventory Writedown 900,000
To recognize inventory writedown.

INVENTORY COST FLOW

The cost of inventories shall be determined by using either of the following cost methods:
A. Specific identification method
B. First in, First Out (FIFO) method
C. Average method
1. Period or Weighted Average
2. Perpetual or Moving Average
SPECIFIC IDENTIFICATION METHOD
Specific identification means the specific costs are attributed to identified items of inventory.
The cost of inventory is determined by simply multiplying the units on hand by their actual
unit cost. This requires records which will clearly determine the actual cost of goods on hand.

Under IAS 2, this method is appropriate for inventories that are segregated for a specific project
and inventories that are not ordinarily interchangeable. Specific identification is favorable
because the flow of inventory cost corresponds with the actual physical flow of goods, but the
use of this method is very costly to implement.

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Illustration 5: Specific Identification Method

FALCO Corp. sells three colors of chairs, Yellow, Orange, and Violet which has an identical
selling price of P60.00 each. Beginning balances for January 1, 2021 consists of 500 Yellow
units, 600 Orange units and 700 Violet Units.
The purchases for these units are as follows: 3,200 units of Yellow chairs at P25.00 each; 2,000
units of Orange chairs at P35.00 each; and 1,500 units of Violet chairs at P40.00 each.
Chairs sold for the year are as follows: 3,000 units of Yellow chairs, 2,300 units of Orange chairs
at P35.00 each; and 2,000 units of Violet chairs.
Required: Compute for the ending inventory cost and gross profit on the information above
using specific identification.
Ending Inventories Computation:
Yellow Orange Violet Total
Units of beginning inventories 500 600 700 1,800
Purchased units 3,200 2,000 1,500 6,700
Sold units (3,000) (2,300) (2,000) (7,300)
Units of ending inventories 700 300 200 1,200
Cost per unit P 25.00 P 35.00 P 40.00
Cost of ending inventories P 17,500 P 10,500 P 8,000 P 36,000

Gross Profit Computation:

Sales:
Yellow (P60.00 x 3,000) 180,000
Orange (P60.00 x 2,300) 138,000
Violet (P60.00 x 2,000) 120,000 438,0000
Cost of Sales:
Yellow (P25.00 x 3,000) 75,000
Orange (P35.00 x 2,300) 80,500
Violet (P40.00 x 2,000) 80,000 (235,500)
Gross Profit 202,500

FIRST IN, FIRST OUT (FIFO)

The FIFO 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 or
produced.
The inventory is thus expressed in terms of recent or new prices while the cost of goods sold
is representative of earlier or old prices.
Notes on the Use of FIFO Approach:
1. This method favors the statement of financial position in that the inventory is stated at
current replacement cost.
2. In a period of inflation or rising prices, the FIFO method would result to the highest net
income.
3. In a period of deflation or declining prices, the FIFO method would result to the lowest net
income.
4. FIFO approach, either by periodic or perpetual inventory systems, the inventory costs are
the same.

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AVERAGE METHOD
The weighted average cost method allows you to mingle the costs of similar items purchased
and use weighted average to measure inventories held, either on a periodic basis or as shipment
is received.
Weighted Average - Periodic
The cost if the beginning inventory plus the total cost of purchases during the period is divided
by the total units purchased plus those in the beginning inventory to get the weighted average
unit cost. Such weighted average unit cost is then multiplied by the units on hand to derive at
the inventory value. Thus, the formula can be derived as:
𝑇𝑜𝑡𝑎𝑙 𝑔𝑜𝑜𝑑𝑠 𝑎𝑣𝑎𝑖𝑙𝑎𝑏𝑙𝑒 𝑓𝑜𝑟 𝑠𝑎𝑙𝑒
𝑨𝒗𝒆𝒓𝒂𝒈𝒆 𝒖𝒏𝒊𝒕 𝒄𝒐𝒔𝒕 =
𝑇𝑜𝑡𝑎𝑙 𝑛𝑢𝑚𝑏𝑒𝑟 𝑜𝑓 𝑢𝑛𝑖𝑡𝑠 𝑎𝑣𝑎𝑖𝑙𝑎𝑏𝑙𝑒 𝑓𝑜𝑟 𝑠𝑎𝑙𝑒

Weighted Average – Perpetual or Moving Average

Under this method, a new weighted average unit cost must be computed after every purchase
and purchase return.
The total cost of goods available every purchase and purchase return are divided by the total
units available for sale at this time to get a new weighted average unit cost. Such new weighted
average unit cost is then multiplied by the units on hand to get the inventory cost.
Illustration 6: FIFO and Average Method
ARLERT COMPANY showed the following information during the year:
Units Unit Cost Total Cost
Jan. 1 Beginning balance 20,000 P 45 900,000
31 Sale 5,000
Apr. 1 Purchase 15,000 50 750,000
Jul. 31 Sale 18,000
Oct. 1 Purchase 25,000 60 1,500,000
31 Purchase return 10,000 60 600,000
Dec. 31 Sale 12,000

Required: Compute the cost of ending inventory and cost of goods sold using the following
approaches (Round off cost per unit and final answers to two decimal places):
A. FIFO – periodic
B. FIFO – perpetual
C. Weighted average
D. Moving average
Requirement A: FIFO - Periodic
Ending inventory: Units Unit Cost Total Cost
From Oct. 1 Inventory 15,000 P 60 900,000
Cost of goods sold computation:
Inventory, beginning 900,000
Add: Net Purchases (1.5M + 0.75M – 0.6M) 1,650,000
Total goods available for sale 2,550,000
Less: Inventory, ending (900,000)
Cost of goods sold 1,650,000

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Requirement B: FIFO – Perpetual

Inventory ending balance and cost of goods sold balance under FIFO – periodic and FIFO –
perpetual will yield the same answer.
Ending inventory: Units Unit Cost Total Cost
From Oct. 1 Inventory 15,000 P 60 900,000
Cost of goods sold computation:
January 31 Sale (5,000 x 45) 225,000
July 31 Sale (15,000 x 45) 675,000
(3,000 x 50) 150,000
Dec. 31 Sale (12,000 x 50) 600,000
Cost of goods sold 1,650,000

Requirement C: Weighted Average Method

Units Unit Cost Total Cost
Jan. 1 Beginning balance 20,000 P 45 900,000
Apr. 1 Purchase 15,000 50 750,000
Oct. 1 Purchase 25,000 60 1,500,000
31 Purchase return (10,000) 60 (600,000)
Goods available for sale 50,000 2,550,000
Less Sales: (35,000)
Ending inventory 15,000

Weighted average
𝑨𝒗𝒆𝒓𝒂𝒈𝒆 𝒖𝒏𝒊𝒕 𝒄𝒐𝒔𝒕 =
𝑃 2,550,000
= P 51.00 15,000 P 51 765,000
]
50,000 𝑢𝑛𝑖𝑡𝑠
Cost of goods sold computation:
Inventory, beginning 900,000
Add: Net Purchases (1.5M + 0.75M – 0.6M) 1,650,000
Total goods available for sale 2,550,000
Less: Inventory, ending (765,000)
Cost of goods sold 1,785,000
Requirement D: Moving Average Method
Units Unit Cost Total Cost
Jan. 1 Beginning balance 20,000 P 45.00 900,000
31 Sale (5,000) 45.00 (225,000)
Balance 15,000 45.00 675,000
Apr. 1 Purchase 15,000 50.00 750,000
Balance 30,000 47.50 1,425,000
Jul. 31 Sale (18,000) 47.50 (855,000)
Balance 12,000 47.50 570,000
Oct. 1 Purchase 25,000 60.00 1,500,000
Balance 37,000 55.95 2,070,000
Oct. 31 Sale (10,000) 60.00 (600,000)
Balance 27,000 54.44 1,470,000
Dec. 31 Sale (12,000) 54.44 (653,280)
Balance 15,000 54.44 816,720

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Cost of goods sold computation:

January 31 Sale 225,000
July 31 Sale 855,000
Dec. 31 Sale 653,280
Cost of goods sold 1,733,280
RELATIVE SALES PRICE METHOD
When different commodities are purchased at a lump sum, the single cost is apportioned among
the commodities based on their respective sales price. This is based on the philosophy that cost
is proportionate to selling price.

Illustration 7: Relative Sales Price Allocation

PYXIS Corp. purchased products X,Y and Z with a basket price of P3,000,000. The sales prices
of the products X, Y and Z are as follows:
Product Sales Price
A 500,000
B 1,500,000
C 3,000,000
Required: Compute for the assigned cost of the inventories X, Y and Z.
Allocation of Basket Price:
Product Sales Price Fraction Allocated Cost
A 500,000 500,000/5,000,000 300,000
B 1,500,000 1,500,000/5,000,000 900,000
C 3,000,000 3,000,000/5,000,000 1,800,000
Total 5,000,000 3,000,000

STANDARD COSTS
Standard costs are predetermined product costs established on the basis of normal levels and
supplies, labor, efficiency and capacity utilization.
Standard costs are predetermined and once determined, is applied to all inventory movements
– inventories, goods available for sale, purchases and goods sold or placed in production. IAS
2 states that the standard cost method may be used for convenience if the results approximate
cost. However, the standards set should be realistically attainable and are reviewed and revised
regularly in the light of current conditions.

LAST IN, FIRST OUT (LIFO)

The LIFO method assumes that “the goods last purchased are first sold” and consequently the
goods remaining in the inventory at the end of the period are those first purchased or produced.
The inventory is thus expressed in terms of old prices while the cost of goods sold is
representative of recent or new prices.
This method favors the income statement because there is matching of current cost against
current revenue, the cost of goods sold being expressed in terms of current or recent cost.
The use of LIFO permits income manipulation, such as making year-end purchases designed to
preserve existing inventory layers.
Thus, under IAS 2, LIFO is not permitted to be used as an inventory cost formula.

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CHANGE IN INVENTORY METHOD

Change in inventory method, i.e., FIFO to weighted average or vice versa is regarded as change
in accounting policy under IAS 8 Accounting Policies, Changes in Accounting Estimates and
Errors. Therefore, the change should be applied retrospectively, but because of the
counterbalancing effect of the error of inventory, the effect maybe computed as follows
(example from FIFO to weighted average):
Ending inventory, prior year using FIFO
(year prior to the date of change inventory) xxx
Less: Ending inventory, prior year using weighted average
(year prior to the date of change inventory) (xxx)
Overstated (understated) ending inventory xxx
If the ending inventory of last year was overstated, net income and retained earnings last year
was overstated. Thus, the adjusting entry on the date of change would be:
Retained Earnings xxx
Inventory, beginning xxx
On the date of change, the effect would be overstatement of beginning inventory, net income
this year is understated but the ending retained earnings would be correct.
If the ending inventory of last year was understated, net income and retained earnings last year
was understated. Thus, the adjusting entry on the date of change would be:
Inventory, beginning xxx
Retained Earnings xxx
On the date of change, the effect would be understatement of beginning inventory this year, net
income this year is overstated but the ending retained earnings would be correct since the effect
of the error is counterbalancing.
Illustration 8: Change in Inventory Costing Method
On January 1, 2022, CONNIE Corp. decided to change from FIFO method of inventory valuation
to weighted average method. Balances of inventory under each method were:
Date FIFO Weighted Average
December 31, 2020 1,000,000 900,000
December 31, 2021 1,200,000 1,350,000
December 31, 2022 1,320,000 1,200,000
Required: Prepare the necessary journal entries and compute for the amount that CONNIE
should report as the effect of this accounting change in its 2022 statement of retained earnings
(disregard income tax effect).
2022
Dec. 31 Inventory, beginning 150,000
Retained Earnings, 1/1/2022 150,000
To adjust inventory from change from FIFO to weighted average.
Ending inventory – weighted average, 12/31/2021 1,350,000
Less: Ending inventory – FIFO, 12/31/2021 (1,200,000)
Retained earnings, 1/1/2022 understated 150,000
The ending inventory for 2020 was disregarded in computing for the effect on the Retained
Earnings on December 31, 2021 or at the beginning of 2022 because of the counterbalancing
effect of the error in the ending inventory.

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PURCHASE COMMITMENTS

A purchase commitment is a noncancelable agreement to purchase goods sometime in the

future at a fixed price and fixed quantity.
When there is a reasonable certainty that inventories purchased under purchase commitments
become impaired, loss on purchase commitment should be recognized in the period such
impairment has been determined. Any recovery may be recognized as gain but such gain to be
recognized should be limited to the loss recognized previously.

PROFORMA JOURNAL ENTRIES

Particulars Noncancelable Cancelable
1. Commitment to No journal entry. No journal entry.
purchase inventory
in the future
2. The value of the Loss on Purchase No journal entry.
inventory Commitment xxx
purchased under Liability on Purchase
the purchase Commitment xxx
commitment is
determined to have
been impaired
3. The goods are Purchases xxx Inventory xxx
received Liability on Purchase Loss on Purchase
Commitment xxx Commitment (if any) xxx
Loss on Purchase Gain on Purchase xxx
Commitment (if any) xxx Commitment (if any)
Accounts Payable xxx Accounts Payable xxx
Gain on Purchase
Commitment (if any) xxx

Illustration 9: Purchase Commitments

On November 25, 2022, GABI COMPANY entered into a commitment to purchase 10,000 units
of tumblers on February 15, 2023 at a price of P310.00 per unit.
On December 31, 2021, the market price of tumbler is P270.00 per unit. On February 15, 2023,
the market price of tumbler is P300.00 per unit.
Required: Prepare the necessary journal entries assuming the purchase commitment is:
A. Noncancelable
B. Cancelable
Requirement A: The purchase commitment is noncancelable.
2022
Nov. 25 NO ENTRY.
Dec. 31 Loss on Purchase Commitment 400,000
Liability on Purchase Commitment 400,000
To recognize difference from purchase commitment
and value at end of reporting date.

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Market price, 12/31/2022 (10,000 units x P270) 2,700,000

Less: Market price, 11/25/2022 (10,000 units x P310) (3,100,000)
Loss on purchase commitment (400,000)
2023
Feb. 15 Purchases (10,000 units x P300) 3,000,000
Liability on Purchase Commitment 400,000
Accounts Payable (10,000 units x P310) 3,100,000
Gain on Purchase Commitment 300,000
To record acquisition of goods.
Requirement B: The purchase commitment is cancelable.
2022
Nov. 25 NO ENTRY.
Dec. 31 NO ENTRY.
2023
Feb. 15 Purchases (10,000 units x P300) 3,000,000
Loss on Purchase Commitment 100,000
Accounts Payable (10,000 units x P310) 3,100,000
To record acquisition of goods.

USE OF ESTIMATE IN INVENTORY VALUATION

In many cases, it is necessary to know the approximate value of inventory when it is not possible
to take a physical count or even if the count is possible, the same may prove costly, difficult or
inconvenient at the moment.
There are two widely accepted procedures for approximating the value of inventory:
1. Gross profit method
2. Retail inventory method
GROSS PROFIT METHOD
The gross profit method is based on the assumption that the rate of gross profit remains
approximately the same from period to period and therefore the ratio of cost of goods sold to
net sales is relatively constant from period to period.
Formulas under the Gross Profit Method
Goods available for sale xxx
Less: Cost of goods sold (xxx)
Inventory, ending xxx
Goods available for sale
Items that usually affect the goods available for sale are:
Inventory, beginning xxx
Add: Net Purchases
Purchases xxx
Add: Freight in xxx
Less: Purchase returns, allowances and discounts (xxx) xxx
Goods available for sale xxx

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Cost of goods sold

The gross profit method is so called because the cost of goods sold is computed through the
use of gross profit rate. The cost of goods sold is computed as follows:
a. Net sales multiplied by cost ratio
b. Net sales divided by sales ratio
Sales allowance and sales discount
Under estimation of inventory valuation, sales allowance and sales discount are ignored, that is,
not deducted from sales. The reason is that while these items decrease the amount of sales,
they do not affect the physical volume of goods sold.
To deduct sales allowance and sales discount from sales would result to overstatement of
inventory with a consequent understatement of cost of goods sold and overstatement of gross
income.
Illustration 10: Gross Profit Method
KIRSTEIN COMPANY holds a large quantity of inventories that it is hard to count in the
warehouse and their system is not that sophisticated for inventory management. Due to this
problem, KIRSTEIN adapted inventory estimation using gross profit method. KIRSTEIN reported
the following information for the current year:
Inventory, beginning 9,000,000
Purchases 37,000,000
Freight in 2,000,000
Purchase returns and allowances 3,500,000
Purchase discounts 1,500,000
Sales 45,000,000
Sales returns 3,000,000
Sales allowances 500,000
Sales discounts 1,000,000
A physical inventory at year-end resulted in an ending inventory costing Php 4,000,000. The
entity also noted unsold goods held on consignment not included in the count with selling price
of Php 1,000,000 are in the hands of the consignee. The gross profit was 40% on based on
cost.
Required: Compute for the following.
A. Cost of goods available for sale
B. Cost of goods sold
C. Estimated cost of inventory shortage/overage
Requirement A: Cost of Goods Available for Sale
Inventory, beginning 9,000,000
Purchases 37,000,000
Freight in 2,000,000
Purchase returns and allowances (3,500,000)
Purchase discounts (1,500,000) 34,000,000
Cost of Goods Available for Sale 43,000,000

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Requirement B: Cost of Goods Sold

Sales 45,000,000
Sales returns (3,000,000)
Net sales 42,000,000
Divide by Sales ratio 140%
Cost of goods sold 30,000,000
Sales discounts, for the purposes of inventory estimation, shall be ignored.
Requirement C: Cost of Inventory Shortage/Overage
Cost of Goods Available for Sale 43,000,000
Cost of Goods Sold (30,000,000)
Ending inventory 13,000,000
Ending inventory per physical count (4,000,000)
Cost of inventory shortage 9,000,000
RETAIL INVENTORY METHOD
The retail inventory method is often used in the retail industry for measuring inventory of large
number of rapidly changing items with similar margin for which is impracticable to use other
costing method. The use of the retail inventory method requires that records be kept which
must show the following data:
a. Beginning inventory at and at retail price
b. Purchases during the period at cost and at retail price
c. Adjustments to the original retail price such as additional markup, markup cancellation, mark
down and markdown cancellation
d. Other adjustments such as departmental transfer, breakage, shrinkage, theft, damaged
goods and employee discount
Formulas under the Retail Inventory Method
In principle and procedures, the formula for the retail inventory method is similar to the gross
profit method. The difference is that under the retail inventory method, the ending inventory is
expressed in terms of selling price.
Goods available for sale at retail or selling price xxx
Less: Net sales (Gross sales minus sales returns only) (xxx)
Ending inventory at selling price xxx
Multiply by cost ratio xxx
Ending inventory at cost xxx
The following enumerates the treatment of items in the determination of inventory using retail
inventory method:
a. Purchase discount – deduction from purchases at cost only.
b. Purchase return – deduction from purchases at cost and retail.
c. Purchase allowance – deduction from purchases at cost only.
d. Freight in – deduction from purchases at cost only.
e. Departmental transfer in or debit – addition from purchases at cost and retail.
f. Departmental transfer in or debit – deduction from purchases at cost and retail.
g. Sales discount and sales allowance – disregarded, meaning not deducted from sales.
h. Sales return – deducted from sales.

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i. Employee discounts – added to sales.

Employee discounts are special discounts usually not recorded because they are already
deducted from the sales price, thus only the net sales price is recorded. Consequently, the
amount of sales is understated. Thus, the employee discounts are added back to sales.
j. Normal shortage, shrinkage, spoilage and overage – this is deducted from goods available
for sale at retail. Any normal shortage is usually absorbed or included in cost of goods sold.
k. Abnormal shortage, shrinkage, spoilage and overage – this is deducted from goods
available for sale at cost and retail. Any abnormal amount is reported separately as loss.
The following items, in the determination of the inventory at retail and for the purposes of
computing the cost ratio, the following items should be considered:
a. Original retail – the sales price at which the goods are first offered for sale
b. Initial markup – original markup on the cost of goods.
c. Additional markup – increase in sales price above the original sales price.
d. Markup cancellation – decrease in sales price that does not decrease the sales price below
the original sales price.
e. Net additional markup or net markup – markup minus markup cancellation.
f. Markdown – decrease in sales price below the original sales price.
g. Markdown cancellation – increase in sales price that does not increase the sales price
above the original sales price.
h. Net markdown – markdown minus markdown cancellation.
i. Maintained markup – difference between cost and sales price after adjustment for all the
above items. Sometimes, this referred to as “mark-on”.
Approaches in the Use of Retail Inventory Method
To obtain the appropriate inventory value under the retail inventory method, three approaches
are followed, namely:
1. Conservative or conventional or lower of cost and net realizable value approach
Under the conservative approach, net markup is included, and net markdown is excluded in
determining the cost ratio in order to arrive a conservative cost.

𝐺𝑜𝑜𝑑𝑠 𝑎𝑣𝑎𝑖𝑙𝑎𝑏𝑙𝑒 𝑓𝑜𝑟 𝑠𝑎𝑙𝑒 𝑎𝑡 𝑐𝑜𝑠𝑡

𝐶𝑜𝑠𝑡 𝑟𝑎𝑡𝑖𝑜 =
𝐺𝑜𝑜𝑑𝑠 𝑎𝑣𝑎𝑖𝑙𝑎𝑏𝑙𝑒 𝑓𝑜𝑟 𝑠𝑎𝑙𝑒 𝑎𝑡 𝑟𝑒𝑡𝑎𝑖𝑙 𝑒𝑥𝑐𝑙𝑢𝑑𝑖𝑛𝑔 𝑛𝑒𝑡 𝑚𝑎𝑟𝑘𝑑𝑜𝑤𝑛
2. Average cost approach
Under the average cost approach, both net markup and net markdown is included in
determining the cost ratio.
𝐺𝑜𝑜𝑑𝑠 𝑎𝑣𝑎𝑖𝑙𝑎𝑏𝑙𝑒 𝑓𝑜𝑟 𝑠𝑎𝑙𝑒 𝑎𝑡 𝑐𝑜𝑠𝑡
𝐶𝑜𝑠𝑡 𝑟𝑎𝑡𝑖𝑜 =
𝐺𝑜𝑜𝑑𝑠 𝑎𝑣𝑎𝑖𝑙𝑎𝑏𝑙𝑒 𝑓𝑜𝑟 𝑠𝑎𝑙𝑒 𝑎𝑡 𝑟𝑒𝑡𝑎𝑖𝑙
3. FIFO approach
Under the FIFO approach, it is similar to average cost approach that both net markup and
net markdown is included in determining the cost ratio, however, a current cost ratio is
determined every year considering the net purchases during the year and excluding the
beginning inventory. The FIFO approach is based on the assumption that markup and
markdown apply to goods purchased during the year and not the beginning inventory.
𝐺𝑜𝑜𝑑𝑠 𝑎𝑣𝑎𝑖𝑙𝑎𝑏𝑙𝑒 𝑓𝑜𝑟 𝑠𝑎𝑙𝑒 𝑎𝑡 𝑐𝑜𝑠𝑡 𝑚𝑖𝑛𝑢𝑠 𝑏𝑒𝑔𝑖𝑛𝑛𝑖𝑛𝑔 𝑖𝑛𝑣𝑒𝑛𝑡𝑜𝑟𝑦 𝑎𝑡 𝑐𝑜𝑠𝑡
𝐶𝑜𝑠𝑡 𝑟𝑎𝑡𝑖𝑜 =
𝐺𝑜𝑜𝑑𝑠 𝑎𝑣𝑎𝑖𝑙𝑎𝑏𝑙𝑒 𝑓𝑜𝑟 𝑠𝑎𝑙𝑒 𝑎𝑡 𝑟𝑒𝑡𝑎𝑖𝑙 𝑚𝑖𝑛𝑢𝑠 𝑏𝑒𝑔𝑖𝑛𝑛𝑖𝑛𝑔 𝑖𝑛𝑣𝑒𝑛𝑡𝑜𝑟𝑦 𝑎𝑡 𝑟𝑒𝑡𝑎𝑖𝑙

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Cities of Mandaluyong and Pasig

A summary on inventory estimation using retail inventory method are as follows:

COST RETAIL
At cost only:
Freight in xx
Purchase allowance (xx)
Purchase discount (xx)
At retail only:
Mark-up xx
Mark-up cancellation (xx)
Mark-down (xx)
Mark-down cancellation xx
At cost and retail:
Beginning inventory xx xx
Purchase xx xx
Purchase returns (xx) (xx)
Departmental transfer in xx xx
Departmental transfer out (xx) (xx)
Abnormal losses (xx) (xx)
Goods available for sale xx xx
Sales xx
Sales returns (xx)
Employee discounts xx
Normal losses, shrinkages, wastes xx
Ending inventory at retail xx
Multiply by: Cost Ratio (Conservative, Average or FIFO) xx
Ending inventory at cost xx
Illustration 10: Retail Inventory Method
SPRINGER COMPANY, a grocery store, used the retail inventory method to approximate the
ending inventory. During the current year, SPRINGER reported the following information:
Cost Retail
Beginning inventory 200,000 700,000
Purchases 3,370,000 4,380,000
Freight in 70,000
Purchase returns 25,000 40,000
Purchase discount 45,000
Net markup 60,000
Net mark down 340,000
Sales 4,000,000
Sales discounts 20,000
Sales returns 80,000

Required: Compute for the ending inventory using the following approach (Round off cost ratio
and final answers to two decimal places):
a. Conservative approach
b. Average cost approach
c. FIFO approach

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 RIZAL TECHNOLOGICAL UNIVERSITY
Cities of Mandaluyong and Pasig

To summarize the use of retail method, the following table is presented below:

Cost Retail
Beginning inventory 200,000 700,000
Purchases 3,300,000 4,380,000
Freight in 140,000
Purchase return (25,000) (40,000)
Purchase discount (45,000)
Net markup 60,000
Goods available for sale – conservative 3,570,000 5,100,000
Markdown (340,000)
Goods available for sale – average 3,570,000 4,760,000
Less: Net sales
Sales 4,000,000
Sales return (80,000) 3,920,000
Ending inventory at selling price 840,000
Cost ratios:
a. Conservative (3,570,000/5,100,000) 70.00%
b. Average cost (3,570,000/4,760,000) 75.00%
3,570,000 − 200,000
c. FIFO 83.00%
4,760,000 − 700,000
Ending inventory at cost
a. Conservative (840,000 x 70%) 588,000
b. Average (840,000 x 75%) 630,000
c. FIFO (840,000 x 83%) 697,200
FINANCIAL STATEMENTS PRESENTATION OF INVENTORIES
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.
Required Disclosures:
An entity shall disclose the following:
a. The accounting policies adopted in measuring inventories, including the cost formula used;
b. The total carrying amount of inventories and the carrying amount in classifications
appropriate to the entity;
c. The carrying amount of inventories carried at fair value less costs to sell;
d. The amount of inventories recognized as an expense during the period;
e. The amount of any write‑down of inventories recognized as an expense in the period
f. The amount of any reversal of any write‑down that is recognized as a reduction in the
amount of inventories recognized as expense in the period
g. The circumstances or events that led to the reversal of a write‑down of inventories
h. The carrying amount of inventories pledged as security for liabilities.

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 RIZAL TECHNOLOGICAL UNIVERSITY
Cities of Mandaluyong and Pasig

INVENTORIES UNDER IFRS FOR SMALL AND MEDIUM ENTITIES (SMEs)

Inventories of a small and medium entity (SME) are initially measured at cost plus any directly
attributable cost. Initial measurement concepts of IFRS for SMEs and full IFRS are the same.

Upon subsequent measurement, SMEs shall measure inventories at the lower of cost and
estimated selling price less costs to complete and sell.

INVENTORIES UNDER IFRS FOR SMALL ENTITIES (SEs)

Inventories of a small entity (SE) are initially measured at cost plus any directly attributable cost.
Initial measurement concepts of IFRS for SEs and full IFRS are the same also.

Upon subsequent measurement, SMEs shall measure inventories at the lower of cost and
estimated selling price less costs to complete and sell.

Disclosures for SMEs and SEs

SMEs and SEs shall disclose the following:
a. The accounting policies adopted in measuring inventories, including the cost formula used;
b. The total carrying amount of inventories and the carrying amount in classifications
appropriate to the entity;
c. The amount of inventories recognized as an expense during the period;
d. Impairment losses recognized or reversed in profit or loss; and
e. The total carrying amount of inventories pledged as security for liabilities.

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Cities of Mandaluyong and Pasig

THEORIES: TRUE or FALSE. Read the statements below and determine if the following statement
is true or false.

1. Land and any other kinds of assets can be classified as part of inventories if the entity is
using these assets in their operating and administrative needs such as production of goods
and services.

2. In FOB shipping point, the buyer is responsible for the delivery charges. Hence, such cost
will be considered as freight out and will become part of operating expenses.

3. In consigned goods, the ownership of the goods remains with the consignor.

4. Goods sold under buyback arrangements is included in the inventory of the transferee.

5. Companies using periodic inventory system is required to perform physical inventory count
to determine year-end inventories.

6. In purchase commitments, a loss is recorded in the period of the price reduction if the
purchase price falls after a purchase commitment has been made.

7. Whether FIFO periodic or weighted average – period inventory costing is applied, the result
in the computation will be the same such the cost of sales, ending inventory and gross
profit.

8. In gross profit method of estimating inventories, purchase returns, allowances and

discounts are all taken into consideration when computing net purchases.

9. The principle behind inventories that shall be measured at lower of cost and net realizable
value is based on principle of conservatism.

10. Retail inventory method can be applicable to businesses that have numerous products to
offer and variety of goods and monitoring their costs one by one would be burdensome
such as sari-sari stores, groceries and department stores.

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 RIZAL TECHNOLOGICAL UNIVERSITY
Cities of Mandaluyong and Pasig

PROBLEMS: Answer the following requirements. Prepare supporting computations as

necessary.

PROBLEM 1:
HANNES COMPANY provided the following data on December 31, 2022:

Items counted in the warehouse (including P50,000 unsalable goods) 4,050,000

Special order items included in the count specifically segregated per contract 100,000
Goods held on consignment, included in the count 250,000
Items in the receiving department, returned by customer in good condition 50,000
Items ordered and in the receiving department 400,000
Items ordered, invoice received but goods not received, freight is on the
account of seller 300,000
Items ordered, invoice received but goods not received, freight is on the
account of buyer 240,000
Items shipped today, invoice mailed, FOB shipping point 250,000
Items shipped today, invoice mailed, FOB destination 150,000
Goods out on consignment at sales price, cost P150,000 200,000
Items currently being used for window display 200,000
Items on counter for sale 800,000
Items in receiving department, refused because of damage 180,000
Items in the hands of salesmen 75,000
Goods held by customers on trial 80,000
Items in the shipping department 250,000
Goods sold under installment basis; goods are in the hands of the customers 220,000
Goods purchased under installment basis, included in the count 260,000

Required: Compute for the correct amount of the inventory

PROBLEM 2:
NILE COMPANY is a merchandising business. NILE COMPANY’s inventories at the end of
reporting period, December 31, 2022:
Type Units Unit Cost Selling Price Selling Cost
PARADIS 300 P 2,000 P 4,500 P 1,000
ROSE 600 1,600 3,800 2,500
MARIA 400 1,200 4,300 1,600
SHIGANSHINA 800 1,800 4,200 1,900

Required: Compute for the following:

A. Inventories to be reported in the statement of financial position
B. Loss on inventory writedown
C. Journal entries using direct method and allowance method

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 RIZAL TECHNOLOGICAL UNIVERSITY
Cities of Mandaluyong and Pasig

PROBLEM 3:
BRAUN COMPANY began selling memorabilia at the beginning of 2022 with 20,000 units of
condominium with unit cost of Php 80M. Purchased condominiums for 2022 follow (from
earliest to latest):
Type Units Unit Cost
ARMOR 2,000 P 100
CART 8,000 110
BEAST 6,000 120
JAW 9,500 100
WARHAMMER 14,500 90
The inventory revealed 16,000 units on hand on December 31, 2022.
Required: Compute the cost of ending inventory for the year under:
A. FIFO – periodic
B. Weighted average - periodic
C. Specific identification (assuming the inventory comes from BEAST, 6,000 units and
WARHAMMER, 10,000 units).

PROBLEM 4:
PIECK COMPANY reported the following information for the current year:
Inventory, beginning 4,000,000
Purchases 20,800,000
Freight in 1,600,000
Purchase returns and allowances 2,800,000
Purchase discounts 1,200,000
Sales 32,000,000
Sales returns 2,400,000
Sales allowances 400,000
Sales discounts 800,000
A physical inventory taken at year-end resulted in an ending inventory costing Php 3,200,000.
At year-end, unsold goods out on consignment with selling price of P800,000 are in the hands
of consignee. The gross profit was 40% of sales.
Required: Using the gross profit method of estimating inventory, compute for the estimated
cost of inventory shortage (overage).

PROBLEM 5:
SASHA COMPANY, whose fiscal year ends on December 31, 2022, entered into a noncancelable
purchase commitment with a supplier to purchase an item of inventory. The contract was signed
on July 1, 2022, and the items would be delivered on March 31, 2023. The total contract value
was P1,000,000.

The inventory’s market price on December 31, 2022 was P900,000, while on March 31, 2023,
it was P700,000.

Required: Prepare the necessary journal entries from July 1, 2022 up to March 31, 2023.

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 RIZAL TECHNOLOGICAL UNIVERSITY
Cities of Mandaluyong and Pasig

PROBLEM 6:
HISTORIA CORP., a grocery store, used the retail inventory method to approximate the ending
inventory. During the current year, SPRINGER reported the following information:
Cost Retail
Inventory, Jan. 1, 2022 179,600 200,000
Purchases 475,400 800,000
Freight in 5,000
Purchase returns 50,000 80,000
Purchase discount 23,000
Purchase allowance 10,000
Markup 200,000
Markup cancellation 40,000
Markdown 115,000
Markdown cancellation 10,000
Departmental transfer-in 70,000 100,000
Departmental transfer-out 60,000 90,000
Abnormal loss 20,000 40,000
Sales 775,000
Sales discounts 70,000
Sales returns 80,000
Sales allowances 50,000
Employee discounts 25,000
Normal loss 100,000

Required: Compute for the ending inventory using the following approach (Round off cost ratio
and final answers to two decimal places):
A. Conservative approach
B. Average cost approach
C. FIFO approach

INTERMEDIATE ACCOUNTING PART 2 35