CHAPTER 12

INVENTORIES

Ninia C. Pauig-Lumauan, MBA, CPA

2nd Semester 2020-2021
Lyceum of Aparri

Intermediate Accounting Part 1

 DEFINITION
• Inventories are assets held for sale in the
ordinary course of business, in the
process of production for such sale or in
the form of materials or supplies to be
consumed in the production process or
in the rendering of services.
• Inventories encompasses goods
purchased and held for resale, for
example:
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 DEFINITION

a. Merchandise purchased by a retailer or

trading entity and held for resale.
b. Land and other property held for
resale by a subdivision entity and real
estate developer.
• Ordinary course of business refers to
the necessary, normal or usual
business activities of an entity.

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 CLASSES OF INVENTORIES
• Inventories also encompasses finished
goods produced, goods in process and
materials and supplies awaiting use in the
production process.
• Inventories are broadly classified into two,
namely, inventories of a trading concern
and inventories of manufacturing concern.
• A trading concern is one that buys and sells
goods in the same form purchased.

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 CLASSES OF INVENTORIES

• The term “merchandise inventory” is

generally applied to goods held by a
trading concern.
• A manufacturing concern is one that
buys goods which are altered or
converted into another form before they
are made available for sale.
• The inventories of a manufacturing
concern are:
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 CLASSES OF INVENTORIES
a. Finished Goods - are completed
products which are ready for sale.
Finished Goods have been assigned
their full share of manufacturing costs.
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.
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 CLASSES OF INVENTORIES
c. Raw Materials - No work or process has
been done on them as yet by the entity
inventorying them. Broadly, raw materials
cover all materials used in the
manufacturing operations. However,
frequently, raw materials are restricted to
materials that will be physically
incorporated in the production of other
goods and which can be traced directly to
the end product of the production process.
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 CLASSES OF INVENTORIES

d. Factory or Manufacturing Supplies – are

similar to raw materials but their
relationship to the end product is indirect.
Factory or Manufacturing Supplies may be
referred to as indirect materials. It is
indirect because they are not physically
incorporated in the products being
manufactured. There are other
manufacturing supplies like paint and nails
which become part of the finished
product. Intermediate Accounting Part 1
 CLASSES OF INVENTORIES

d. Factory or Manufacturing Supplies

• However, since the amounts involved are
insignificant, it is impractical to attempt to
allocate their costs directly to the product.
These supplies find their way into the product
cost as part of the manufacturing overhead.
• As a rule, all goods to which the entity has
title shall be included in the inventory,
regardless of location.

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 GOODS INCLUDIBLE IN THE INVENTORY
• The phrase “passing of title” is a legal
language which means “the point of time at
which ownership changes.”
LEGAL TEST
• Is the entity the owner of the goods to be
inventoried?
• If the answer is in the affirmative, the goods
shall be included in the inventory.
• If the answer is in the negative, the goods
shall be excluded in the inventory.
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 LEGAL TEST
• Applying the legal test, the following items
are included in inventory:
a. Goods owned and on hand
b. Goods in transit and sold FOB
destination
c. Goods in transit and purchased FOB
shipping point
d. Goods out on consignment
e. Goods in the hands of salesmen or
agents Intermediate Accounting Part 1
 LEGAL TEST
f. Goods held by customers on approval or
on trial.
• Installment contracts may provide for
retention of title by the seller until the
selling price is fully collected.
• Following the legal test, the goods sold on
installment basis are still the property of
the seller and therefore normally
includible in his inventory.
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 EXCEPTION TO THE LEGAL TEST
• Nonetheless, installment sales is a clear
example of economic substance prevailing
over the legal form.
• However, in such a case, it is an accepted
accounting procedure to record the
installment sale as a regular sale involving
deferred income on the part of the seller
and as a regular purchase on the part of
the buyer.

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 EXCEPTION TO THE LEGAL TEST
• Thus, the goods sold on installment are
included in the inventory of the buyer and
excluded from that of the seller, the legal
test to the contrary notwithstanding.
• WHO IS THE OWNER OF GOODS IN
TRANSIT?
• This will depend on the terms, whether
FOB destination or FOB shipping point.
FOB means free on board.
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WHO IS THE OWNER OF GOODS IN TRANSIT?

• Under FOB destination, ownership of

goods purchased is transferred only upon
receipt of the good by the buyer at the
point of destination.
• Thus, under FOB destination, the goods in
transit are still the property of the seller.
• Accordingly, the seller shall legally be
responsible for freight charges and other
expenses up to the point of destination.
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WHO IS THE OWNER OF GOODS IN TRANSIT?

• On the other hand, if the term is FOB

shipping point, ownership is transferred
upon shipment of the goods and
therefore, the goods in transit are the
property of the buyer.
• Accordingly, the buyer shall legally be
responsible for freight charges and other
expenses from the point of shipment to
the point of destination.
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WHO IS THE OWNER OF GOODS IN TRANSIT?
• In practice, during an accounting period,
the accountant normally records purchases
when goods are received and sales when
goods are shipped, regardless of the
precise moment at which title passed.
• This procedure is expedient and no
material misstatements occur in the
financial statements because title usually
passes in the same accounting period.
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WHO IS THE OWNER OF GOODS IN TRANSIT?

• However, the accountant should carefully

analyse the invoice terms of goods that
are transit at the end of the accounting
period to determine who has legal title.
• Accordingly, adjustments are in order if
errors are committed in recording
purchase and sales.

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 FREIGHT TERMS

• Freight Collect – – This means that the

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

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 FREIGHT TERMS

• The terms “FOB destination” and “FOB

shipping point” determine ownership of
the goods in transit and the party who is
supposed to pay the freight charge and
other expenses from the point of shipment
to the point of destination.
• The terms “freight collect” and “freight
prepaid” determine the party who actually
paid the freight charge but not the party
who is supposed to legally pay the freight
charge. Intermediate Accounting Part 1
 MARITIME SHIPPING TERMS

• FAS or free alongside- a seller who ships

FAS must bear all expenses and risk
involved in delivering the goods to the
dock next to or alongside the vessel on
which the goods are to be shipped.
• The buyer bears the cost of loading and
shipment and thus, title passes to the
buyer when the carrier takes possession
of the goods.
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 MARITIME SHIPPING TERMS

• CIF or Cost, insurance and freight- Under

this shipping contract, the buyer agrees to
pay in a lump sum the cost of the goods,
insurance cost and freight charge. The
shipping contract may be modified as CF
which means that the buyer agrees to pay
in a lump sum the cost of the goods and
freight charge only.

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 MARITIME SHIPPING TERMS
• In either case, the seller must pay for the
cost of loading. Thus, title and risk of loss
shall pass to the buyer upon delivery of
the goods to the carrier.
• Ex-Ship – a seller who delivers the goods
ex-ship bears all expense and risk loss
until the goods are unloaded at which
time title and risk of loss shall pass to the
buyer.
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 CONSIGNED GOODS

• A consignment is a method of marketing

goods in which the owner called the
consignor transfer physical possession
certain goods to an agent called the
consignee who sells them on the owner’s
behalf.
• Consigned goods shall be included in the
consignor’s inventory and excluded from
the consignee’s inventory.

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 CONSIGNED GOODS
• Freight and other handling charges on
goods out on consignment are part of
the cost of goods consigned.
• When consigned goods are sold by the
consignee, a report is made to the
consignor together with a cash
remittance for the amount of sales minus
commission and other expenses
chargeable to the consignor.
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 CONSIGNED GOODS
• For example, a consignee sells consigned
goods for P 100,000. This amount is
remitted to the consignor less
commission of P 15,000 and advertising
of P 2,000. The consignor simply records
the cash remittance from the consignee
as follows:
Cash 83,000
Commission 15,000
Advertising 2,000
Sales 100,000

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 CONSIGNED GOODS
• Incidentally, consigned goods are
recorded by the consignor by means of a
memorandum entry.
• Thus, it may be necessary for the
consignor to maintain subsidiary ledger
for various consignees.

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 CONSIGNED GOODS
STATEMENT PRESENTATION
• Since inventories are acquired for
production, sale or consumption and
acquisitions normally approximate the
entity’s need for the current operating
cycle, these are generally classified as
current assets.

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 SALE 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 an asset.
• For example, the buyer does not
recognize any inventory when:

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SALE WITH UNUSUAL RIGHT OF RETURN

a. 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.

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 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. If the
prospective customer is satisfied with the
good, he purchases. 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 purchase it.

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 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.

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 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 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:

Intermediate Accounting Part 1

 BILL AND HOLD ARRANGEMENT

a. 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, and
d. The seller cannot use the goods or sell
them to another customer.
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 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 when he
makes the final installment payment.
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 LAY AWAY SALE
• However, when significant payments
have already been made, the goods may
be included in the buyer’s inventory,
provided delivery is probable.
TYPE OF ARRANGEMENT INCLUDED IN THE INVENTORY OF
1. FOB shipping point  Buyer
2. FOB destination  Seller
3. Consigned goods  Consignor
4. Product financing and pledge  Borrower
5. Sale with unusual right of return  Buyer, except when unsalable
6. Sale on trial (for approval)  Seller
7. Bill and hold  Buyer
8. Lay away  Seller
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 LINE ITEMS
• The inventories shall be presented as one
line item in the statement of financial
position but the details of the inventories
shall be disclosed in the notes to
financial statements.
• For example, the note shall disclose the
composition of the inventories of a
manufacturing entity as finished goods,
goods in process, raw materials and
manufacturing supplies.

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 ACCOUNTING FOR INVENTORIES

• The major objectives of inventory

accounting are:
a. Proper determination of periodic
income through the recognition of
appropriate costs that are matched with
revenue.
b. Proper representation of inventories
recognized as assets in the financial
statements.
Intermediate Accounting Part 1
 ACCOUNTING FOR INVENTORIES
• Two systems are offered in accounting for
inventories, namely, periodic system and
perpetual system.
• The periodic system calls for the physical
counting of goods on hand at the end of the
accounting period to determine quantities.
The quantities are then multiplied by the
corresponding unit costs to get the
inventory value for balance sheet purposes.
This approach gives actual or physical
inventories. Intermediate Accounting Part 1
 ACCOUNTING FOR INVENTORIES
• The periodic inventory procedure is
generally used when the individual
inventory items have small peso
investment, such as groceries, hardware
and auto parts.
• On the other hand, the perpetual system
requires the maintenance of records
called stock cards that usually offer a
running summary of the inventory inflow
and outflow. Intermediate Accounting Part 1
 ACCOUNTING FOR INVENTORIES
• Inventory increases and decreases are
reflected in the stock cards and the resulting
balance represents the inventory. This
approach gives book or perpetual inventories.
• The perpetual inventory procedure is
commonly used when the inventory items
treated individually represent a relatively
large peso investment, such as jewelry and
cars.

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 ACCOUNTING FOR INVENTORIES
• In an ideal perpetual system, the stock
cards are kept to reflect and control both
units and costs. Consequently, the entity
would be able to know inventory on hand
at a particular moment in time.
• In recent years, the widespread use of
computers has enabled practically all
large trading and manufacturing entities
to maintain a perpetual inventory system.
Intermediate Accounting Part 1
 ACCOUNTING FOR INVENTORIES
• With computers, the entities can
conveniently and effectively store and
retrieve large amount of inventory data.
• When the perpetual system is used, a
physical count of the units on hand
should at least be made once a year or at
frequent intervals to confirm the
balances appearing on the stock cards.

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 ILLUSTRATION: PERIODIC VS PERPETUAL
PERIODIC SYSTEM PERPETUAL SYSTEM
1. Purchases 300,000 1. Merchandise 300,000
Inventory
Accounts Payable 300,000 Accounts Payable 300,000
To record purchase of merchandise on To record purchase of merchandise on
account. account.
2. Freight In 20,000 2. Merchandise 20,000
Inventory
Cash 20,000 Cash 20,000
To record payment of freight on the To record payment of freight on the
purchases. purchases.
3. Accounts Payable 30,000 3. Accounts Payable 30,000
Purchase Return 30,000 Merchandise 30,000
Inventory
To record return of merchandise to supplier. To record return of merchandise to supplier.

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 ILLUSTRATION: PERIODIC VS PERPETUAL
PERIODIC SYSTEM PERPETUAL SYSTEM
4. Accounts 400,000 4. Accounts 400,000
Receivable Receivable
Sales 400,000 Sales 400,000
To record sale of merchandise on account To record sale of merchandise on account.
at 40% Gross Profit.
5. Sales Return 25,000 Cost of Goods Sold 240,000
. Accounts 25,000 Merchandise 240,000
Receivable Inventory
To record return of merchandise from To record sale of merchandise on account
customer. at 40% Gross Profit.
6. Merchandise 65,000 Under the perpetual system, the cost of
Inventory-End merchandise sold is immediately recorded
Income 65,000 because this is clearly determinable from
Summary the stock card.
To record adjustment of ending inventory
– P 65,000.

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 ILLUSTRATION: PERIODIC VS PERPETUAL
PERPETUAL SYSTEM
5. Sales Return 25,000
. Accounts Receivable 25,000
To record return of merchandise from customer.
Merchandise Inventory 15,000
Cost of Goods Sold 15,000
To record return of merchandise from customer with a cost of P 15,000
(60% x 25,000).
6. Adjustment of ending inventory
As a rule, the ending merchandise inventory is not adjusted. The balance
of the merchandise inventory account represents the ending inventory.

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 INVENTORY SHORTAGE OR OVERAGE
• In the illustration, the merchandise
inventory account has debit balance of P
65,000. 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 average. For example, if the
physical count shows inventory on hand of
P 55,000, the
Inventoryfollowing
Shortage adjustment
10,000 is
necessary: Merchandise Inventory 10,000
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 INVENTORY SHORTAGE OR OVERAGE
• The inventory shortage is usually closed
to cost of goods sold because this is often
the result of normal shrinkage and
breakage in inventory.
• However, abnormal and material
shortage shall be separately classified
and presented as other expense. If
considered abnormal spoilage, the
shortage is charged as loss, e.g. theft,
pilferage and loss on casualty.

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INVENTORY SHORTAGE OR OVERAGE
• Note that the 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 goods
sold.
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 SUMMARY
PERPETUAL SYSTEM PERIODIC SYSTEM
All increases and decreases Increases and decreases in
in inventory are recorded in inventory during the period are
the “Inventory” account. recorded in the “Purchases”,
“Freight In”, “Purchase Returns”,
and “Purchase Discounts”
accounts, as appropriate.

 “Cost of Goods Sold” is “Cost of Goods Sold” is not

debited when inventory is sold recorded.
and 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.

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 SUMMARY
PERPETUAL SYSTEM PERIODIC SYSTEM
Does not require the use of  Requires the use of the
any formula to determine “Cost following formula when
of Goods Sold” because this determining “Cost of Goods
information is readily available Sold”:
from the ledger. Beginning Inventory xxx
Net Purchases xxx
TGAS xxx
Ending Inventory
(Physical Count) (xxx)
Cost of Goods Sold xxx
===

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 INVENTORY ERRORS
• Under the periodic system, cost of goods sold
is a residual amount. Thus, it is affected by
errors in ending inventory, beginning inventory
and net purchases. When cost of goods sold is
misstated, so is the profit for the period.
• We will use the following guidance in
determining the effects on inventory on profit
under a periodic system:
ENDING INVENTORY : PROFIT – DIRECT RELATIONSHIP

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 INVENTORY ERRORS
• Ending Inventory and Profit have a direct
relationship. Direct relationship means
that if ending inventory is understated,
profit is also understated.
• From the main guidance above, we can
also derive the following relationships:
 Beginning Inventory and Purchases:
Profit – Inverse relationship
 Ending Inventory : Cost of Goods Sold –
Inverse relationship
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 INVENTORY ERRORS
 Beginning Inventory and 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.
• If a contra-purchases account )i.e. Purchase
returns and discounts) is misstated, its
effect would be the reverse of the effect of
the purchases account.
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 INVENTORY ERRORS

• For example, if purchase returns is

understated, the effect on profit is also
understatement, a direct relationship –
the reverse of the effect of purchases on
profit which is inverse relationship.
• If an adjunct-purchases account (i.e.
Freight in) is misstated, the effect would
be the same as the effect of the
purchases account.
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 INVENTORY ERRORS

• For example, if freight in is understated, the

effect on profit overstatement – the same
as the effect of purchases on profit which is
inverse relationship.
• Errors in purchases account (and contra
and adjunct accounts) affect only cost of
goods sold and profit. They do not affect
ending inventory because ending inventory
is determined independently through
physical count.
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 INVENTORY ERRORS
• 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.

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