Audit of Inventories,

Cost of Sales and

other related
accounts
(Part 3)
 CHANGE IN INVENTORY METHOD

Under PAS 8, Accounting Policies, Changes in accounting Estimates and Errors,

change in inventory method is regarded as change in accounting policy.

The change should be applied retrospectively.

 CHANGE IN INVENTORY METHOD
Ending inventory, prior year using FIFO XX
Ending inventory, prior year using WA XX
Overstated/Understated ending inventory XX
If the EI of prior year was overstated, net income If the EI of prior year was understated, net income
and retained earnings of prior year were overstated. and retained earnings of prior year were
Thus adjusting entry on the date of change would understated. Thus adjusting entry on the date of
be: change would be:

Retained earnings XX Merchandise inv. XX

Merchandise inv. XX Retained earnings XX

On the date of change, the effect would be: On the date of change, the effect would be:
overstatement of the beginning inventory this year understatement of the beginning inventory this year
net income this year is understated net income this year is overstated
Retained earnings is correct Retained earnings is correct
PURCHASE COMMITMENT

• It 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.
 PURCHASE COMMITMENT

Transaction Journal entries

1. Commitment to purchase inventory in the future No journal entry (disclosure of the existence of the
commitment in the financial statements)

2. The value of the inventory purchased under the Loss on purchase commitment XX
purchase commitment is determined to have been Liability on purchase commitment XX
impaired.
3. The goods are received. Purchases (at lower of purchase commitment XX
and replacement cost)
Accounts payable/Cash XX
4. Recovery before goods is received. Liability on purchase commitment XX
Gain market recovery XX
FOREIGN CURRENCY INVENTORY TRANSACTIONS

• It is a purchase transaction denominated in a currency other than

Philippine peso. The Philippine company buys inventory from a foreign
company and the payment s denominated in a currency of the foreign
company. The Philippine company buys a foreign currency in order to pay
its liabilities in foreign currency.
• A gain or loss may be recognized because of the fluctuation in the currency
exchange rate. This is known as the foreign currency exchange risk.
 FOREIGN CURRENCY INVENTORY TRANSACTIONS

Transaction Journal entries

1. Date of purchase Record both the inventory and payable account at the
spot rate on the date of the transaction.

2. Reporting date Remeasure the monetary items (accounts payable) at

the spot rate on the reporting date. Foreign currency
gain or loss is included in profit or loss.
3. Settlement date Record the amount paid using the spot rate on the
settlement date. Any difference between the amount
paid and the recorded liability is treated as gain or loss
in profit or loss.

NOTE: As per PAS 21:

monetary asset and liability are translated at the closing rate (rate at reporting date)
nonmonetary asset and liability are measured at historical rate (rate at the date of the
transaction)
 INVENTORY ESTIMATION

Use of Inventory Estimation

• for insurance purposes

• To prove the correctness or reasonableness of physical count
• For interim financial statements

Two approaches in Estimating the value of inventory

• Gross profit method

• Retail inventory method
 GROSS PROFIT METHOD FORMULAS
Gross profit based on sales Gross profit based on cost
Sales XX 100% Sales XX 125%
Less: CGS XX 75% Less: CGS XX 100%
Gross profit XX 25% Gross profit XX 25%
Gross profit = GP rate x Sales Gross profit = GP rate x Sales/Sales ratio
CGS = Cost ratio x Sales CGS = Sales/Sales ratio

NOTE: Only sales returns are deducted to arrive at the amount of sales for the purpose
of determining the gross profit ratio. Sales discounts and allowances are ignored since
although these items reduce sales, they don’t reduce the physical quantity of inventory
sold.
 GROSS PROFIT METHOD FORMULAS
Average Gross Profit Overall Gross Profit
GP rate Yr 1 + Yr 2 +Yr n GP rate Yr 1 + Yr 2 +Yr n
No. of years Sales Yr 1 + Yr 2 + Yr n

NOTE: Use overall GP when there is no trend on the GP ratios and the problem is silent
as to what GP will be used.
To compute for estimated ending inventory:

Merchandising company: Mfg. Company Finished goods:

Total goods available for sale XX Total goods available for sale XX
Less: Estimated cost of goods sold XX Less: Estimated cost of goods sold XX
Estimated ending inventory XX Estimated ending FG inventory XX

Mfg. company Work in process: Mfg. company Direct materials:

Total cost of goods placed into process XX Total direct materials available for use XX
Less: Cost of goods manufactured XX Less: Direct materials used XX
Estimated ending WIP inventory XX Estimated ending DM inventory XX
To compute for inventory lost/destroyed:
Merchandising company:
Mfg. company, finished goods:
Estimated ending inventory XX
Estimated ending inventory XX
Less: Salvage or scrap value XX
Less: Salvage or scrap value XX
In-transit goods (owned) XX
Consigned goods XX
Consigned goods XX
Other inventories owned not in
Other inventories owned not in
the warehouse during the fire XX
the warehouse during the fire XX
Inventory loss XX
Inventory loss XX

Mfg. company, direct materials:

Mfg. company, work in process:
Estimated ending inventory XX
Estimated ending inventory XX
Less: Salvage or scrap value XX
Less: Salvage or scrap value XX
RM in transit (owned) XX
WIP inventories owned not in
RM owned not in the warehouse
the warehouse during the fire XX
during the fire XX
Inventory loss XX
Inventory loss XX
 RETAIL INVENTORY METHOD

Pragmatic way of determining cost by starting with the selling price and deducting a
suitable estimate of the profit margin.

Often used in retail industry for measuring inventories of large numbers of rapidly changing
items with similar margins
 RETAIL INVENTORY METHOD
Basic Formula
Goods available for sale at retail XX
Less: Net Sales
Sales XX
Less: Sales return only XX XX
Ending inventory at retail XX
X Cost ratio XX
Ending inventory at cost XX
 RETAIL INVENTORY METHOD
Definition of terms:

Initial mark up – original mark up on the cost of goods, or the amount added to the original
cost to get the original retail price.
Original retail – the sales price at which the goods are first offered for sale.
Additional markup – increase in the sales price above the original sales price, or the amount
added to the original retail price.
Markup cancellation – a decrease in the sales price that does not reduce the sales price below
the original sales price.
Net markup – additional markup minus markup cancellation
Markdown – a decrease in the sales price below the original price
Markdown cancellation – an increase in sales price that does not raise the sales price above
the original sales price.
Net markdown – markdown minus markdown cancellation
Maintained markup (‘markon”) – difference between cost and sales price after adjustment for
all the above items.
 RETAIL INVENTORY
Items to add/deduct to compute TGAS
METHOD
COST RETAIL
Beginning inventory Add Add
Purchases Add Add
Freight in Add -
Purchase return Less Less
Purchase discount Less -
Purchase allowance Less -
Departmental transfer in Add Add
Departmental transfer out Less Less
Abnormal shortage, shrinkage, spoilage, breakage Less Less
Markup - Add
Markup cancellation - Less
Markdown - Less
Markdown cancellation - Add
TGAS TGAS

***Normal Shrinkage, Employee discounts – added to Sales

 RETAIL INVENTORY METHOD
To compute cost ratio:
Methods Beginning Marks up Markdown Formula
inventory

Conservative/ Include Include Exclude GAS at cost

Conventional/LCM GAS at retail exc. Net markdown
Average Include Include Include GAS at cost
GAS at retail

FIFO Exclude Include Include GAS at cost minus Beg. Inv at cost
GAS at retail minus Beg. Inv at retail

NOTE: PAS 2, par. 22, requires either the average cost or the FIFO approach. The
standard requires that markdowns should be included in determining the cost ratio.

Conservative approach is not acceptable under PFRS, but is used under US GAAP.
 DERECOGNITION OF INVENTORY: RECOGNITION AS AN EXPENSE

When inventories are sold, the carrying amount of those inventories shall be recognized as
an expense in the period in which the related revenue is recognized (cost of good sold)

Some inventories may be allocated to other asset accounts, these are recognized as an
expense during the useful life of the asset.
REQUIRED DISCLOSURES
• Accounting policy for inventories
• Carrying amount, generally classified as merchandise, supplies, materials, work in
progress, and finished goods. The classification depend on what is appropriate for the
enterprise.
• Carrying amount of any inventories carried at fair value less cost to sell
• Amount of any write-down of inventories recognized as expense in the period
• Amount of any reversal of a write-down to NRV and the circumstances that led to such
reversal
• Carrying amount of inventories pledged as security for liabilities
• Cost of inventories recognized as expense (cost of good sold)