Audit of Inventories,

Cost of Sales and

other related
accounts
(Part 2)
INVENTORIES

PAS 2, par. 6, defines inventories as assets which are 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 service.

• Assets which are held for sale in the ordinary course of business (finished goods)
• Assets in the process of production for sale in the ordinary course of business (work in process)
• Materials and supplies to be consumed in the production (raw materials)
• Purchased subcomponents
• Goods held by a trader for resale
Inventories are broadly classified into two:
Merchandising/ - merchandise
Trading Company inventory

- finished goods

Manufacturing
- work in process
Company

- raw materials

- materials and
supplies

- factory supplies
INITIAL/SUBSEQUENT RECOGNITION

Initial measurement –
AT COST

Subsequent
- Statement of
measurement – at
INVENTORIES Financial Position –
LOWER of COST or Net
Current Assets
Realizable Value - Direct method
Cash purchases :
DEDUCT
- Statement of Cash
Presentation –
Flows – Operating
Financial Statements
Activities - Indirect method
Increase in Inventory:
Statement of DEDUCT
Comprehensive
Income – Cost of Good
sold
INITIAL RECOGNITION

An entity should recognize inventory only when:

• a the entity controls the asset as a result of past events
• it is probable that future economic benefits will flow to the entity
INITIAL MEASUREMENT : AT COST

COST of Inventories:

• all cost of purchase

• all cost of conversion
• all other costs incurred in bringing the inventories to their present
location and condition.
INITIAL MEASUREMENT : AT COST

COST of Inventories:

A. Cost of purchase (PITO)

P Purchase price

I Import duties and other taxes (except those recoverable from taxing authorities)

T Transport and other handling costs

O Other costs directly attributable to the acquisition of finished goods, materials and services.
INITIAL MEASUREMENT : AT COST

COST of Inventories:
Cost of purchase

Note: Any trade discounts, rebates or other similar items are deducted in determining the costs of
purchase.

Note: When an inventory is bought on a deferred credit terms, the excess of price over the amount to be
paid under normal credit terms is recognized as interest expense over the period of the financing.

Note: PAS 2 does not permit exchange differences arising directly on the recent acquisition of inventories
invoiced in a foreign currency to be included in the cost of the inventories.
INITIAL MEASUREMENT : AT COST

COST of Inventories:
B. Cost of conversion

Direct labor
Joint products

Direct materials - Where joint products are

- allocated to each unit produced and their cost of
Variable production of production based on conversion are not separately
overhead the actual use of the identifiable, cost of conversion
production facilities. are allocated between them on a
Overhead rational and consistent basis.
- allocated to each unit
Fixed production of production based on
overhead the normal capacity of
the production facilities.
INITIAL MEASUREMENT : AT COST

COST of Inventories:
B. Cost of conversion

Behavior of cost (within relevant range)

Type of cost In total Per unit

Variable cost TVC changes as activity level VC per unit remains the same over
changes wide ranges of activity

Fixed cost TFC remains the same even when Ave. FC per unit goes down as
the activity level changes activity level goes up.
INITIAL MEASUREMENT : AT COST

COST of Inventories:

C. Other costs – included only to the extent that they are incurred in bringing the
inventories to their present location.
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 a
repetitive basis.

2. Storage costs – can be included for products that require a maturation process or substantial amount of time to create.

3. Non-production overheads or costs of designing products for specific customer – can be included if they contribute in
bringing the inventories to their present condition and location.
INITIAL MEASUREMENT : AT COST

EXCLUDED from Cost of Inventories (SASAFI)

S Selling costs

A Abnormal amounts of wasted materials, labor or other production costs.

S Storage costs (unless essential to the production process)

A Administrative overheads unrelated to production

F Foreign exchange differences arising directly on the recent acquisition of inventories invoiced in a foreign currency

I Interest cost when inventories are purchased with deferred settlement terms.
INITIAL MEASUREMENT : AT COST

Cost of inventories of a service provider

Consist primarily of the labor and other cost of personnel directly engaged in providing the service, including
supervisory personnel and attributable overhead.

The inventories of a service provider may simply be described as work in progress.

Note: Labor and other costs relating to sales and general administrative personnel are not included but are
recognized as expenses in the period in which they are incurred.
 FLOW OF COSTS

Merchandising/Trading Company

Cost Balance Sheet – Income

• Merchandise Inventories Statement –
purchases • Merchandise Expenses
Inventory • Cost of Sales
 FLOW OF COSTS

Manufacturing Company

Costs Balance Sheet – Income Statement –

• Material purchases Inventories Expenses
• Direct labor • Raw material • Cost of goods sold
• Manufacturing • Work in process
overhead • Finished goods
 Direct/Raw Materials Work in Process

Beginning balance Ending balance Beginning balance Ending balance

Net purchases Direct materials used Direct materials used Cost of goods manufactured
Direct labor
Applied FOH

Finished Goods

Beginning balance Ending balance

Cost of goods manufactured Cost if goods sold
 Cost of Goods Sold

Merchandise inventory, beginning XX

Add: Net Purchases XX
Total goods available for sale XX
Less: Merchandise inventory, ending (XX)
Cost of goods sold XX
 Statement of Cost of Goods Manufactured and Sold

Raw materials inventory, beginning XX

Add: Net purchases
Purchases XX
Add: Freight in XX
Gross Purchases XX
Less: Purchase returns and allowances (XX)
Purchase discounts (XX) XX
Raw materials available for use XX
Less: Raw materials end (XX)
Raw materials used XX
Add: Direct labor XX
Applied manufacturing overhead XX
Total manufacturing cost XX
Add: Work in process, beginning XX
Total cost of goods placed into process XX
Less: Work in process, ending (XX)
Cost of goods manufactured XX
Add: Finished goods, beginning XX
Total cost of goods available for sale XX
Less: Finished goods, ending (XX)
Cost of goods sold XX
Items to be included in Inventory

As a rule, goods to which the entity has title shall be included in the inventory,
regardless of location.
“Passing of title” - the point of time at which ownership changes.
Items to be included in Inventory

WHOSE INVENTORY IS IT?

1. Shipping terms

FOB Shipping point Buyer

Free alongside (FAS) Buyer
Cost, insurance and freight (CIF) Buyer
Ex-ship Seller
FOB destination Seller
Items to be included in Inventory
WHOSE INVENTORY IS IT?

2. Terms of Sale

Bill and hold arrangement Buyer

Installment sale Buyer
Special-order goods Buyer
Sales with right of return Buyer
Layaway sales Seller
Sales out on approval Seller
Sales with buyback agreement (or product Seller
financing arrangement)
Segregated goods in the warehouse Seller
Consigned goods Consignor (seller)
Example: RM Company provided the ff. data at year end:
Example: RM Company provided the ff. data at year end:
Answer: Correct amount of Inventory = 5,700,000
 TWO SYSTEMS OF ACCOUNTING FOR INVENTORIES
PERPETUAL INVENTORY SYSTEM
Used for low-volume, high-cost items
For low-value inventory – use of POS (point-of-sale) devices
connected to the company’s inventory system
Inventory account is updated for each purchase, sale and return
of inventory
Physical count is performed to determine the accuracy of the
balance per records
Purchase returns, discounts and allowances are recorded by
crediting the inventory account.
Freight in is debited directly to the inventory account
Inventory shortage/overage and loss on inventories is charged to Inventory shortage/overage (normal or abnormal) is always part
cost of goods sold only if considered normal. If abnormal,
treated as other operating expense or other income.
Account used: Inventory
PERIODIC INVENTORY SYSTEM
Used for relatively low value inventory items
Inventory account is updated only at the end of the period.
Physical count is performed to determine the ending balance of
the inventory and to compute for the cost of good sold. Cost of
good sold is a residual amount.
Purchase returns, discounts and allowances are recorded by
crediting the appropriate purchase account.
Freight incurred when inventory was purchased is debited to
“Freight in” account.
of cost of goods sold.
Accounts used: Inventory beginning, inventory ending,
purchases, freight in, purchase returns, purchase allowance and
purchase discount
 Inventory Shortage/Overage

Merchandise inventory, beginning (units) XX

Add: Net Purchases (units) XX
Units available for sale XX
Less: Units sold (XX)
Units that should be on hand XX
Less: Actual units on hand (XX)
Inventory shortage/Overage XX
 TWO METHODS OF ACCOUNTING FOR PURCHASES

GROSS METHOD NET METHOD

Purchases are recorded at the total Purchases are recorded at invoice
invoice price price net of cash discounts available
(whether taken or not)

Purchase discounts are recorded Purchase discounts are recorded

only when taken – under Purchase only when not taken – under
Discounts account Purchase Discounts Lost account
 TRADE DISCOUNTS VS. CASH DISCOUNTS

TRADE DISCOUNT CASH DISCOUNT

Given to encourage order in large Given to encourage prompt
quantities payment

Deducted from list price to Deducted from invoice price

determine the invoice price

Not recorded in the books of either Recorded by buyer as purchase

the buyer or seller discount; recorded by seller as sales
discount
 TRADE DISCOUNTS VS. CASH DISCOUNTS

TRADE DISCOUNT CASH DISCOUNT

Given to encourage order in large Given to encourage prompt
quantities payment

Deducted from list price to Deducted from invoice price

determine the invoice price

Not recorded in the books of either Recorded by buyer as purchase

the buyer or seller discount; recorded by seller as sales
discount
SUBSEQUENT MEASUREMENT : AT LOWER OF COST AND NET REALIZABLE VALUE

Net realizable value is the estimated net selling price in the ordinary course of
business less estimated cost of completion and the estimated costs necessary to
make the sale.
Raw materials and factory supplies
NRV is the replacement cost. Materials and other supplies held for use in the production of inventories are not written
down below cost if the finished products in which they will be incorporated are expected to be sold at or above cost.

Work in process or partially completed goods

NRV is estimated selling price less estimated cost of completion less estimated cost to sell.

Finished goods
Estimated selling price less estimated cost to sell
SUBSEQUENT MEASUREMENT : AT LOWER OF COST AND NET REALIZABLE VALUE

Inventories are usually written down to net realizable value item by item. In some circumstances,
however, it may be appropriate to group similar or related items.

Any write-down to NRV should be recognized as an expense (i.e., added to cost of goods sold) in the
period in which the write-down occurs.

Any reversal should be recognized in the income statement (i.e., deducted from cost of goods sold)
in which the reversal occurs.
 TWO METHODS OF ACCOUNTING FOR THE LOWER
OF COST AND NET REALIZABLE VALUE
DIRECT METHOD ALLOWANCE METHOD
Known as “Cost of goods sold Known as “loss method” because a
method” because any loss on loss account “loss on inventory
inventory writedown is not writedown” is debited and a
accounted for separately but valuation account “allowance for
“buried” in the cost of goods sold inventory writedown” is credited

Preferably, the allowance method is used in order that the effects of the
writedown and reversal of writedown can be clearly identified.

PAS 2, par. 36, requires disclosure of the amount of any inventory writedown
and any reversal of inventory writedown.
 TWO METHODS OF ACCOUNTING FOR THE LOWER
OF COST AND NET REALIZABLE VALUE
DIRECT METHOD ALLOWANCE METHOD
Merchandise inventory, beg. (at LCNRV) Merchandise inventory, beg. (at cost)
Add: Net purchases Add: Net purchases
Total goods available for sale Total goods available for sale
Less: Merchandise inventory, end (at LCNRV) Less: Merchandise inventory, end (at cost)
CGS after inventory write-down CGS before inventory write-down
Add: Loss on inventory write-down
Less: Gain in reversal of inventory write-down
CGS after inventory write-down
 TWO METHODS OF ACCOUNTING FOR THE LOWER
OF COST AND NET REALIZABLE VALUE

To compute gain or loss: If the required allowance increases, an

Merchandise inventory, end (at cost)
Less: Merchandise inventory, end (at LCNRV)
Required allowance
Less: Allowance for inventory write-down, beg.
Loss (Gain) on inventory write-down
additional loss is recognized.
If the required allowance decreases, a
gain on reversal of inventory write-down
is recorded.
However, the gain is limited only to the
extent of the allowance balance.
COST FORMULAS/COST METHODS
To determine the amount of cost to be compared to the net realizable value,
the following may be used:
Specific Identification method
Used for inventories that are not ordinarily interchangeable and goods or services produced
and segregated for specific projects

FIFO Method (periodic/perpetual)

Weighted average method (periodic)

Unit cost = Total goods available for sale/Units available for sale
Cost of Ending inventory = unit cost x units of ending inventory
Cost of sale = unit cost x units sold

Moving average (perpetual)