Inventories

Inventories
According to IAS 2, paragraph 6, inventories are assets of an
enterprise, which are:
a. Held for sale in the ordinary course of business
b. In the process of production for such sales; or
c. In the form of materials or supplies to be consumed in the
production process or in the rendering of services.
For manufacturing:
d. Finished Goods
e. Goods in Process (Work in Process)
f. Raw Materials
g. Factory of Manufacturing Supplies
For merchandising:
h. Merchandise Inventory or simply Inventory
For service provider businesses:
a. Work in process
Summary of flow of costs in the inventory
system
Direct Materials Inventory Work in Process Inventory Fnished Goods Inventory
Beg. Balance Xx Beg. Balance Xx Beg. Balance Xx
+Purchases Xx +Direct Materials used Xx +Cost of goods Xx
manufactured
+Freight in Xx +Direct labor Xx
- Purchase Returns & (Xx) +Factory overhead Xx
Allowances/Purchase
discounts
Total Direct materials xx Total manufacturing costs Xx Total Cost of goods Xx
available for use to account available for sale
Less: End balance (xx) Less: End balance (xx) Less: End balance (xx)
DM materials used Xx Cost of goods Xx Cost of goods sols xx
manufactured
Computation of COGS in different types of
businesses
Cost of Inventory:
1. Cost of purchase – Includes purchase price, import duties and other taxes (except those which are recoverable from tax authorities), and transport,
handling and other costs directly attributable to the acquisition of finished goods, materials and services. Net of trade discounts, rebates and other
similar items.
• Cost of Conversion – Includes direct labor, allocation of fixed and variable production overhead.
• Allocation of fixed production overhead: based on normal capacity
• Normal capacity is the production expected to be achieved on average over a number of periods or seasons under normal circumstances
taking into account the loss of capacity resulting from planned maintenance
• Unallocated fixed overhead is expensed outright
• Allocation of variable production overhead is allocated based on actual use
1. Cost of Agricultural Produce Harvested from Biological Assets
2. Other Costs – Includes costs that incurred in bringing the inventories to their present location and condition.
3. Costs of inventories of service providers – labor and other costs of personnel directly engaged in providing the service, including supervisory
personnel and attributable overhead cost excluding any profit margins and non-attributable overhead.

Exclusions from Cost of Inventory

4. Abnormal amounts of wasted materials, labor, or other production costs
5. Storage costs (unless essentials to the production process)
6. Administrative overheads unrelated to production
7. Selling costs
8. Labor and other costs relating to sales and general administrative personnel
9. Profit margins or non-attributable overheads that are often factored into prices charged by service providers
10. Financing element involved in purchases under deferred payment arrangement. Borrowing costs are capitalized as inventory costs when inventories
Trade and Cash discounts
Purchases of goods is recorded net of trade discounts while cash discounts may be accounted for using one of
the following methods: The gross price method, net price method and allowance method.
Other Costs
Other costs are included in the cost of inventories only to the extent that they are incurred in bringing the
inventories to their present location and condition. Examples of other costs:
1. Borrowing costs – PAS 23 Borrowing costs requires capitalizing interest on inventories that 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 – this 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 – this can be included in
cost if they contribute in bringing the inventories to their present condition and location.
 Items to be included in Inventory quantities
• As a rule, all goods to which the entity has title shall be included in the inventory,
regardless of location. 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, otherwise, shall not be
included.
• Applying the legal test, the following items are included in the inventory:
a. Goods owned and on hand
b. Goods in transit and purchased FOB shipping point
c. Goods out on consignment
d. Goods in the hands of salesmen or agents
e. Goods held by customers on approval or on trial
Items that may require special attention in determining the
proper inventory items at the end of the period
1. Good in Transit
The terms of the shipment determine whether the seller of the buyer includes them in its inventory.
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.
Who paid the freight charge?
• 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.
Other Maritime Shipping Terms
1. 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 transfer of title happens when the carrier takes possession of the
goods
• Similar to FOB shipping point

2. CIF or Cost, Insurance, and freight

• The buyer agrees to pay in lump-sum the cost, insurance, and freight of the goods.
• The seller bears the cost of loading however title transfers to buyer upon delivery of goods to carrier.
• Similar to FOB shipping point
3. Ex-ship
• Seller bears all expenses and risk of loss until goods are unloaded
• Similar to FOB destination

4. F.O.B Shipping Point is also called FOB Seller ; F.O.B destination is also called FOB Buyer
2. Consigned Goods
Goods may be transferred from one party (consignor) to another (consignee) for purpose of sale without the
ownership and ultimate economic control changing hands. The consignor includes goods out on consignment in
its inventory at cost plus the handling and shipping costs incurred in the delivery of the goods to the consignee
while the consignee excludes goods held on consignment in its inventory.
3. Segregated Goods
Special order goods manufactured according to the customer specifications is considered as sold and therefore
excluded from the seller’s inventory. However, goods that are customarily manufactured and constitute stock
items of the enterprise, even if physically segregated, are considered unsold, until they are actually delivered or
picked up by the customers.
4. Conditional Sales and Installment Sales
Under the installment contract the substance of the transaction is that control over the goods has already passed
to the buyer. Goods in the hands of salespersons and agents, goods held by customer on approval and goods held
by others for storage, processing or shipment, should also be shown as part of the ending inventory of the
enterprise that economically controls the goods.
5. Goods sold with Buyback Agreement
The customer does not obtain control of the asset (the inventory), and the transferor shall account for the transfer
as a financing arrangement and shall retain the inventory in its books.
6. Good sold with Refund Offers
The recognition of revenue implies that the corresponding transferred goods be removed from the inventory at
their carrying amount.
7. Lay away Plans and Bill and Hold Sales
Under these circumstances, revenue is recognized when the customer obtains control over the product,
that is when the following conditions have been met:
a. The product must have been identified separately as already belonging to the customer
b. The product must be ready for transfer to the customer
c. The entity does not have ability to use the product or to direct it to another customer

The recognition of revenue is made simultaneously to derecognition of inventory in the seller’s

accounting records.
Illustrative Example 1: Items to be included in
Inventory
You have been assigned to compute for the correct balance of the inventory
account for the year ended December 31, 2019:
Illustrative Example 2: Items to be included in Inventory
Identify the cost as either inventoriable or not, and determine the amount to be included as
part of inventory:
Items
1 Supplier’s gross price for raw materials, P150,000
2 Materials purchased from another on extended credit amounting to P570,000. The price to be paid
under normal credit terms is P550,000.
3 Invoice price of raw materials purchased amounting to P180,000. Quantity discounts are 10%, 5%.

4 Materials purchased from a supplier amounting to P616,000, inclusive of 12% vat. The company is VAT
registered and can claim this is an input VAT.
5 Materials purchased from a supplier amounting to P515,000, inclusive of nonrecoverable purchase tax
of P15,000
6 Costs of transporting raw materials to the business partners, P5,000
7 Import duties paid to authorities on import of raw materials to be used during the manufacturing
process, P25,000
8 Labor costs directly incurred in the processing of raw materials, P420,000
9 Normal amount of wasted labor, P57,000
10 Abnormal amounts of wasted labor, P69,000
11 Variable costs (electricity) incurred in the processing of raw materials, P10,000
 Illustrative Example 3: Items to be included in Inventory
Identify the cost as either inventoriable or not, and determine the amount to be included as
part of inventory:
Items Items
1 Costs of transporting goods to customers on sale, P2,500 12 Storage costs of finished goods, P23,000
2 Non-recoverable purchase taxes charged to customers on sale, P12,000 13 Fixed administration overhead (rent for office): P450,000

3 Non-recoverable sales taxes, P14,400 14 Insurance on in transit inventories, P 17,800

4 Commission payable to salesmen on the sale of goods, P14,500

15 Freight incurred when the inventories were returned and redelivered,
P34,100
5 Provision for bad debts in relation to trade receivables, P56,000
16 Foreign exchange differences arising directly on the recent acquisition
of inventories invoiced in a foreign currency. The peso equivalent
6 Costs of the accounts department, P140,000 when acquired is P567,000 and the peso equivalent when paid is
P577,000.
7 Head office costs relating to the overall management of the business,
P234,000
8 Borrowing costs incurred on inventories that takes substantial amount of
time to create, P122,000
9 Storage costs of a maturing product, P56,000
10 Selling costs, P45,600
11 Nonproduction overheads cost of designing products for specific
customers, P10,000
Illustrative Example 4: Items to be included in Inventory
You have been assigned to compute for the correct balance of the inventory account for the
year ended December 31, 2019:

Answer: 5,979,000
Inventory Accounting System
CASH DISCOUNTS ON INVENTORY PURCHASES ON ACCOUNT
Cash discounts may be recorded using either:

GROSS METHOD
• If the entity adopts the Periodic Inventory System, the Purchases account and the Accounts
payable account are recorded at the gross invoice price while under the Perpetual Inventory
System, the Merchandise Inventory and the Accounts payable accounts are recorded at gross.
• A cash discount taken is recognized only at the time of payment as a credit to Purchase
Discount under Periodic Inventory System and a credit to Merchandise Inventory account if the
Perpetual Inventory System was used.
• Purchase Discount account is presented in the profit or loss section as a deduction to Purchases
account under Periodic Inventory System.
Cash discounts may be recorded using either:

NET METHOD
- If the entity adopts the Periodic Inventory System, the Purchases and the Accounts payable
account are recorded at net of the cash discount while under Perpetual Inventory System, the
Merchandise Inventory and the Accounts payable accounts are recorded at net of cash
discount.
- The Purchase discount is recognized even not taken. Under the Periodic Inventory System, If
payment is done after the discount period, a Purchase discount lost is recognized, which is
taken to profit or loss section of the Statement of Comprehensive Income as part of finance
cost and not capitalized to the inventory account.
INVENTORY PURCHASES ON ACCOUNT
Initial Measurement of Inventory Purchases on Account

List or Quoted Price Xx

Less: Trade discounts, rebates, and other similar items Xx

Initial Measurement (Gross method of recording purchases) Xx

Less: Purchase discount Xx

Initial Measurement (Net method of recording purchases,

Xx
whether discount is taken or not)
CASH DISCOUNTS ON INVENTORY PURCHASES ON
ACCOUNT
Sample illustration: Cash discounts and purchase returns

AP Company entered into the following transactions during the year:

1. On November 2, it purchased inventory amounting to P86,000 with terms of 3/10,
n/30 from Rex Company.
2. On November 4, it purchased inventory with a list price of P150,000 with terms of
20%, 10%, 2/10, n/30 from Rhad Company.
3. On November 6, it returned merchandise with invoice cost of P10,000 to Rex
Company
4. On November 12, it paid accounts to Rex Company
5. On November 22, it paid accounts to Rhad Company.
Required: Prepare the necessary journal entries, assuming the company is using the (a)
Gross Method and (b) Net Method.
 SOLUTION: Sample illustration: Cash discounts and purchase returns
Periodic system (Perpetual system)
Gross Method Net Method

Nov. 2 Purchases (Inventory) P86,000 Purchases (Inventory) P83,420*

Accounts Payable P86,000 Accounts Payable 83,420

Nov. 4 Purchases (Inventory) 108,000 Purchases (Inventory) 105,840**

Accounts Payable 108,000 Accounts Payable 105,840

*86,000 x 97%
**108,000 x 98%
 SOLUTION: Sample illustration: Cash discounts and purchase returns
Periodic system (Perpetual system)
Gross Method Net Method

Nov. 6 Accounts payable 10,000 Accounts payable 9,700

Purchase returns 10,000 Purchase returns 9,700*

(Inventory) (Inventory)

Nov. 12 Accounts payable 76,000 Accounts payable 73,720

Purchase discounts
2,280** Cash 73,720
(Inventory)
Cash 73,720

*10,000 x 97%
**(86,000 – 10,000) x 3%
 SOLUTION: Sample illustration: Cash discounts and purchase returns
Periodic system (Perpetual system)
Gross Method Net Method

Nov. 22 Accounts payable 108,000 Accounts payable 105,840

Purchase discount
Cash 108,000 2,160**
lost*
Cash 108,000

*Purchase discount lost is not capitalized in Inventory. It is presented in finance cost or other expense.
**Invoice price: 108,000
Less: Purchase returns -
Invoice price, subject to discount 108,000
Multiply by: Discount 2%
Purchase discount lost 2,160
 FREIGHT CHARGES
Effect of freight on Accounts Payable

Who SHOULD Who PAID the Journal Entry of buyer to Journal Entry of seller
pay the freight? freight? record the freight to record the freight

a. FOB shipping point, freight Freight-in xx Accounts Receivable xx

prepaid Buyer Seller Accounts Payable xx Cash xx

b. FOB shipping point, freight Freight-in xx

collect Buyer Buyer NO EFFECT
Cash xx

No journal entry on the part Freight out xx

c. FOB destination, freight prepaid Seller Seller
of the buyer Cash xx

d. FOB destination, freight collect Accounts Payable xx Freight out xx

Seller Buyer Cash xx Accounts Receivable xx
FREIGHT CHARGES
ILLUSTRATION
On June 1, 2018, Angelica sold merchandise with a list price of ₱5,000,000 to Ash. Angelica
allowed trade discounts of 20% and 10%. Credit terms were 5/10, n/30 and the sale was made
FOB shipping point. Angelica prepaid ₱200,000 of delivery cost for Ash as an accommodation.
Required: Using the data above, answer the following:
• What amount shall be initially recognized as Purchases assuming Ash records purchases under
the following methods:
a. Gross method
b. Net method

• How much will be remitted by Ash to Angelica if payments are made under he following
independent situations:
a. June 11, 2018
b. June 16, 2018
FREIGHT CHARGES
SOLUTION: ILLUSTRATION

List Price 5,000,000

Less: Trade discount [(5,000,000 x 1,400,000
20%) + (5,000,000 x 80% x 10%)]
Invoice Price (also the initial 3,600,000
measurement under Gross Method)*
Less: Cash discount (P3,600,000 x 5%) 180,000

Initial measurement under Net 3,420,000

Method
*can also be computed by 5,000,000 x 80% x 90%
 FREIGHT CHARGES
SOLUTION: ILLUSTRATION
Journal entries on the part of Ash to compute for net remittance (if payment is made on June 11, 2018):
Periodic system (Perpetual system)

Gross Method Net Method

June 1, 2018 initial measurement Purchases (Inventory) 3,600,000 Purchases (Inventory) 3,420,000
Accounts payable 3,600,000 Accounts payable 3,420,000

Freight prepaid my seller (FOB shipping point) Freight in (Inventory) 200,000 Freight in (Inventory) 200,000
Accounts payable 200,000 Accounts payable 200,000

June 11, 2018 (within the discount period) Accounts payable 3,800,000 Accounts payable 3,620,000
Purchase discounts (Inventory) 180,000 Cash 3,620,000
Cash 3,620,000

Net cash remittance remain the same whether the method is gross or net and whether the system is
perpetual or periodic.
 FREIGHT CHARGES
SOLUTION: ILLUSTRATION
Journal entries on the part of Ash to compute for net remittance (if payment is made on June 16, 2018):
Periodic system (Perpetual system)
Gross Method Net Method
June 1, 2018 initial measurement Purchases (Inventory) 3,600,000 Purchases (Inventory) 3,420,000
Accounts payable 3,600,000 Accounts payable 3,420,000

Freight prepaid my seller (FOB shipping point) Freight in (Inventory) 200,000 Freight in (Inventory) 200,000
Accounts payable 200,000 Accounts payable 200,000

June 16, 2018 (beyond the discount Accounts payable 3,800,000 Accounts payable 3,620,000
period) Cash 3,800,000 Purchase discounts lost* 180,000
Cash 3,800,000

*Purchase discounts lost is not capitalized in inventory. It is presented as finance cost or other expense.
Net cash remittance remain the same whether the method is gross or net and whether the system is
perpetual or periodic.
Inventory Cost Flow
 Inventory cost flow
• A primary issue in accounting for inventories is the determination of the amount to be recognized as an asset and as
an expense.
• The cost of goods available for sale is allocated between the cost of goods sold and the ending inventory by means
of a cost flow assumption.
a. First in first out method (FIFO)
• First come, first sold.
• 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.
• In other words, the FIFO is in accordance with the ordinary merchandising procedure that the goods are sold in the
order they are purchased.
b. Weighted average perpetual method (Moving average method)
• PAS 2, paragraph 27, provides that the weighted average may be calculated on the periodic basis or as each
additional shipment is received depending upon the circumstances of the entity.
• Under this method, a new weighted average unit cost must be computed after every purchase and purchase return.
• Thus, the total cost of goods available after every purchase and purchase return is 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.
• This method requires the keeping of inventory stock card in order to monitor the “moving” unit cost after every purchase.
C. Weighted average periodic method
• The cost of 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 a weighted average unit cost.
• Such weighted average unit cost is then multiplied by the units on hand to derive the inventory value.
• In other words, the average unit cost is computed by dividing the total cost of goods available for sale by the
total number of units available for sale.
d. Specific Identification
• Specific identification means that specific costs are attributed to identified items of inventory.
• The cost of the inventory is determined by simply multiplying the units on hand by their actual unit cost.
• This requires records which will clearly determine the actual costs of goods on hand.
• PAS 2, paragraph 23, provides that this method is appropriate for inventories that are segregated for a specific
project and inventories that are not ordinarily interchangeable.
• The specific identification method may be used in either periodic or perpetual inventory system.
• The major argument for this method is that the flow of the inventory cost corresponds with the actual physical
flow of goods.
• With specific identification, there is an actual determination of cost of units sold and on hand.
• The major argument against this method is that it is very costly to implement even with high-speed computers.
Illustrative Example 2: Cost Formulas

The Sonny Company sells blankets for P30 each. The following was taken from the inventory records during July:

Required: Determine the cost for sales and cost of ending inventory under each the following independent assumptions:
a. FIFO Method (periodic)
b. FIFO Method (perpetual)
c. Weighted-Average Method
d. Moving Average Method
Illustrative Example: Cost Formulas
Illustrative Example: Cost Formulas
 Another example
Units Unit cost Total Cost
Jan. 1 Beginning balance 5,000 200 1,000,000
10 Purchase 5,000 250 1,250,000
15 Sale (7,000)
16 Sale return 1,000
30 Purchase 16,000 150 2,400,000
31 Purchase return (2,000) 150 300,000
Ending balance 18,000
Compute for COGS and Ending Inventory under Answers in the Excel File. Pls check vid lecture and excel file.
1. FIFO – periodic
2. FIFO – perpetual
3. Moving average
4. Weighted average
Standard cost
• Predetermined product costs established on the basis of normal levels of materials, supplies, and labor,
efficiency, and capacity utilization
• May be used for convenience if the results approximate cost
Relative Sales Price Method
• When different commodities are purchased lump-sum, the single cost is apportioned among the commodities
based on their respective sales price.
• Based on the philosophy that cost is proportionate to selling price
For example, products A, B, and C are purchased at basket price of 3,000,000. The products have the following sales
price: 500,000 for A ; 1,500,000 for B ; 3,000,000 for C.

The cost of each product is as follows:

Product A 500,000 5/50 x 3,000,000 300,000

Product B 1,500,000 15/50 x 3,000,000 900,000
Product C 3,000,000 30/50 x 3,000,000 1,800,000
5,000,000 3,000,000
References:

• - Asuncion, D. J., Ngina, M. A., & Escala, R. F. (2017). Applied Auditing. Baguio City: Real
Excellence Publishing.
- Millan, Z. V. (2019). Intermediate Accounting (Vol. 1A). Baguio City: Bandolin Enterprises.
- Robles, N. S., & Empleo, P. M. (2019). Intermediate Accounting (Vol. 1). Mandaluyong City.
• - Valix, C. T., Peralta, J. F., & Valix, C. A. (2019). Intermediate Accounting 1. Manila, Philippines:
GIC Enterprises & Co., Inc.
• Rey Ocampo Online – youtube channel