Ateneo de Zamboanga University

ACCOUNTANCY ACADEMIC ORGANIZATION

A School of Management and Accountancy Student Government

Inventories
Definition
PAS 2 defines inventories as assets:
a. Produced and held for sale in the ordinary course of business (finished goods inventory)
b. In the process of production for such sale (work in process inventory)
c. In the form of materials or supplies to be consumed in production (raw materials inventory)
d. Purchased and held for resale in the ordinary course of business (merchandise inventory)
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 the goods is transferred. However, there may
be cases where the transfer of control (ownership) does not coincide with the transfer of physical
possession. 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:
a. Goods in transit – pertain to goods already shipped by the seller but are not yet received by
the buyer. Goods in transit may form part of the inventories of either the buyer and the seller,
but not both, depending on the terms of the sale contract:
i. 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
“Purchases” (and “Accounts Payable”) upon shipment.
ii. 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 “Purchases” (and “Accounts Payable”) when the goods are received.
b. Consigned Goods – pertain to goods transferred by a consignor to a consignee who will act
as an agent of the consignor in trying to sell the goods. Consigned goods are included in the
consignor’s inventory and are excluded from that of consignee’s. When goods are delivered
to the consignee, the consignor retains ownership of the consigned goods.
Only a memo entry is normally used in recording the consignment. Freight and other
incidental costs of transferring consigned goods to the consignee form part of the cost of the
consigned goods. Repair costs for damages and other maintenance costs are charged as expenses.
c. Inventory financing agreements
i. 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.
ii. 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.
iii. Warehouse financing – a third party holds the inventory and acts as the creditor’s agent.
This arrangement does not result to the transfer of control over the asset.
iv. Loan of inventory – an entity borrows inventory from another entity to be replaced with
the same kind of inventory. This arrangement results to transfer of control over the asset.
The borrower includes the goods he has received in its inventory.
d. Sale with unusual right of return – the buyer does not recognize any inventory when: (a)
the buyer assesses that no economic benefits will be derived from the goods (i.e. 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.

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 Ateneo de Zamboanga University
ACCOUNTANCY ACADEMIC ORGANIZATION
A School of Management and Accountancy Student Government

e. Sale on trial (or approval) – a seller allows a prospective customer to use a good for a given
period of time with an option to purchase the same after the specified period. Under this
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.
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
f. 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.
g. Bill and hold sale – a contract under which an entity bills a customer for a product but the
entity retains physical possession of the product until it is transferred to the customer at a
future date. The goods sold under a bill and hold sale is excluded from the seller’s inventory
and included in the buyer’s inventory at the point of sale when title passes to the buyer and
he accepts the billing.
h. Lay away sale – a type of sale in which goods are delivered only when the buyer makes the
final payment in a series of installments. The goods sold under a lay away sale are included
in the seller’s inventory until the goods are delivered to the buyer after the final installment is
paid. However, when significant payments have already been made, the goods may be
included in the buyer’s inventory provided delivery is probable.
Accounting for inventories
Inventories are accounted for either through:
a. Perpetual inventory system – under this system, the “Inventory” account is updated for
each purchase and sale of inventory. The balance of inventory on hand and cost of goods sold
at any given point of time can be determined by referring to the running totals without the
need of having a physical count of inventories.
Purchases, freight-in, purchase returns, discounts and allowances are recorded as debits
or credits to the “Inventory” account. “Cost of goods sold” is debited and “Inventory” is
credited each time a sale is made.
b. Periodic inventory system – under this 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. Prior to physical count, the balance of the inventory account
represents the beginning balance or the balance from the last physical count. Cost of goods
sold is determined only after the physical count as follows:
Purchases of inventory are debited to the Beginning inventory xx
“Purchases” account; shipping costs are debited Add: Net purchases xx
to the “Freight-in” account; purchase returns, Total goods available for sale xx
discounts and allowances are credited to the Less: Ending inventory (physical count) (xx)
Cost of goods sold xx
“Purchase returns, discounts and allowances”
account. No entry is made to recognize cost of goods sold when inventory is sold.
When an entity uses a perpetual inventory system and a difference exists between the perpetual
inventory balance and the physical inventory count, the difference is recorded in the account
“Inventory Shortage or Overage”. Inventory shortage is charged to cost of goods sold if it is
considered normal spoilage. If considered abnormal spoilage, the shortage is charged to loss.
Measurement of inventories
Inventories are measured at the lower of cost and net realizable value (NRV).

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 Ateneo de Zamboanga University
ACCOUNTANCY ACADEMIC ORGANIZATION
A School of Management and Accountancy Student Government

Cost of inventories
The cost of inventories comprise all:
a. Costs of purchase – include:
i. Purchase price
ii. Import duties
iii. Transport and handling costs (freight-in)
iv. Other costs directly attributable to the acquisition of finished goods, materials and services
The cost of purchase does not include taxes paid which are subsequently recoverable (i.e.
VAT paid by VAT payers). Trade discounts, rebates and similar items are deducted in
determining the costs of purchase.
b. Costs of conversion - include costs incurred directly in converting raw materials into finished
goods. Conversion costs include direct labor and variable and fixed production overheads.
c. Other costs – include only those incurred in bringing the inventories to their present location
and condition. The following costs should be excluded from cost of inventories and
recognized as expenses in the period in which they are incurred:
i. Abnormal amounts of wasted materials, labor or other production costs
ii. Selling costs (i.e. advertising, promotion costs, delivery expense or freight out)
iii. Administrative overheads
iv. Storage costs, unless those costs are necesarry in the production process
Interest expense incurred on borrowings (borrowing costs) made to finance the acquisition or
production of an inventory that meets the definition of a qualifying asset forms part of the cost of
the inventory. All other interests are charged as expenses.
Cost formulas
1. Specific identification – this shall be used for items that are not ordinarily
interchangeable or for items that are individually unique. This cost formula best parallels
the actual costs of specifically identified items of inventory.
2. First-in, First-out (FIFO) cost formula – this cost formula assumes that the items of
inventory that were purchased or produced first are sold first and consequently, the items
remaining in inventory at the end of the period are those most recently purchased or
produced. Thus, the cost of goods sold represents costs from earlier purchases while cost
of ending inventory represents costs from the most recent purchases.
A unique characteristic of FIFO formula is that it yields the same amounts of cost of
goods sold and ending inventory when applied in either a perpetual or periodic system.
3. Weighted average cost formula – under this cost formula, the cost of each item is
determined from the weighted average of the cost of similar items purchased or produced
during the period. The average may be calculated under either periodic or perpetual system.
a. Weighted average cost – Periodic (Simple weighted average) – the weighted
average cost is determined at the end of the period by using the following formula:
Total goods available for sale∈ pesos
WAC=
Total goods available for sale∈units
b. Weighted average cost – Perpetual (Moving average) – a new or moving
weighted average cost is determined after every purchase or as each shipment is
received by dividing total goods available for sale as of that date by the total
quantity of goods available for sale as of that date. The moving average unit cost
is then multiplied by the quantity of goods sold after the latest purchase to
determine cost of goods sold or by the quantity of inventory on hand to determine
ending inventory.

Net realizable value (NRV)

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 Ateneo de Zamboanga University
ACCOUNTANCY ACADEMIC ORGANIZATION
A School of Management and Accountancy Student Government

Subsequent to initial recognition, inventories are measured at the lower of cost or net realizable
value. NRV is the estimated selling price in the ordinary course of business less the estimated
costs of completion and the estimated costs necesarry to make the sale.
Write-down to NRV
In cases where the recoverable amounts of inventories fall below the costs (NRV<Cost), the
inventories may need to be written down to their net realizable value.
If the cost of an inventory exceeds its NRV, the inventory is written down to NRV, the lower
amount. The excess of cost over NRV represents the amount of write-down. If the cost of an
inventory is lower than its NRV (NRV>Cost), no write-down is necesarry.
Write-downs of inventories to NRV are normally charged to cost of goods sold in the period of
write-down. However, write-downs due to abnormal losses are charged to loss.
Reversal of write-downs
A new assessment is made of NRV at each subsequent period. When there is clear evidence of an
increase in NRV which was previously written down below cost, the amount of write-down is
reverted in profit or loss in the period of such reversal so that the new carrying amount is the
lower of the cost and the revised NRV.
However, the amount of reversal to be recognized should not exceed the amount of the original
write-down previously recognized.
Inventory estimation
There may be instances where the value of inventories must be estimated such as when it is not
possible to take physical count. The cost of inventories may be estimated using either the:
a. Gross profit method – under this method, gross profit is assumed to be relatively constant
from period to period. Thus, gross profit is used to compute for the gross profit rate1 (GPR)
which will in turn used to determine the cost ratio2. The cost ratio will be used in estimating
the cost of inventory and cost of goods sold.
1
– Gross profit rate can be expressed as a percentage based on sales (computed by dividing gross
profit by the net sales3) or based on cost (computed by dividing gross profit by cost of goods
sold).
2
– Cost ratio from GPR based on sales = 100% Net sales – GPR based on sales
Cost ratio from GPR based on cost = 100% COGS ÷ % Net sales = 100% COGS ÷ (100% + GPR
based on cost)
3
– Only sales returns are deducted from gross sales in computing for net sales. Sales discounts
and allowances are not deducted.
b. Retail method – under this method, the cost ratio is computed directly without regard to the
gross profit rate while net mark-ups1 and net mark-downs2 are considered. Retail method is
applied using either the (a) average cost method or (b) FIFO cost method
1
– Net mark-up is equals to markups less markup cancellations. Markup refers to the increase above
the original retail price3. Markup cancellation refers to decrease in the selling price that does not
reduce the selling price below the original retail price.
2
– Net markdown is equals to markdowns less markdown cancellations. Markdown refers to the
decrease below the original retail price. Markup cancellation refers to increase in the selling
price that does not raise the selling price below the original retail price.
3
– Original retail price refers to the selling price at which the goods are first offered for sale.
Under Average cost method:
Cost ratio = TGAS at cost ÷ TGAS at sales or retail price
Under FIFO cost method:
Cost ratio = (TGAS at cost – Beg. inventory at cost) ÷ (TGAS at retail - Beg. inventory at retail)
Total goods available for sale at cost is equals to Beg. inventory + Net purchases. When
determining Total goods available for sale at sales price, net mark-ups are added while net
mark downs are deducted.

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