Lesson Title: Inventories

Lesson Objectives:
At the end of the module, the learners will be able to:
• Explain the inclusion or exclusion of an item in inventories.
• Describe periodic and perpetual inventory systems.
• Explain the recognition of inventories as expense.
• Describe the presentation and disclosure requirements for inventories.
Lectures and annotations:
Nature of inventories
PAS 2 defines inventories as assets:
a) Held for sale in the ordinary course of business (retailer)
b) In the process of production for such sale (WIP)
c) In the form of materials or supplies to be consumed in the production process or in
the rendering of services (raw materials)
Items included in inventories:
• Merchandise purchased by a retailer and held for sale
• Land and other property of a real estate entity held for resale
• Finished goods produced by the entity
• Work in progress being produced by the entity
• Materials and supplies awaiting use in the production process

Goods in transit (inventory in transit)

Terms of shipment determine the owner:
• Free on board (FOB) shipping point- the title to the goods is transferred to the buyer
upon shipment of the goods. The buyer is responsible for the delivery charges (freight
in, part of the initial cost of the inventory).
• FOB destination- the title to the goods is transferred to the buyer only upon receipt of
the goods at the point of destination. The seller is responsible for the delivery charges
(freight out, this is selling expenses and will be part of operating expenses).
There is no complex if the one responsible for the settlement of freight actually paid for
it:
• FOB shipping point – freight collect
• FOB destination – freight prepaid

Accounting problem arises if the party not responsible for paying the freight is the one
who actually paid for it:
• FOB shipping point – freight prepaid
• FOB destination – freight collect
In this case, adjustments would be made to correct the amounts and accounts involved.
Illustration: On Dec 30, 2020, ABC Co sold and shipped goods to XYZ Inc for P200,000.
Freight charges paid on the same date amounted to P20,000. XYZ received the goods on
Jan 3, 2021 and settled its obligation on Jan 4, 2021.
Provide the corresponding journal entries for the ff:
1) FOB shipping point – freight collect
2) FOB shipping point - freight prepaid
3) FOB destination – freight collect
4) FOB destination – freight prepaid
Goods on consignment:
Owned by the consignor (principal) since it has control over the goods and not the
consignee (agent).

Goods used as collateral

Owned by the borrower not the lender.

Goods sold
The goods are excluded from the seller’s inventory if the transaction qualifies for
recognition as revenue. In accordance with PFRS 15, revenue is recognized as control
over the goods is passed.
In determining control, an entity must consider the following facts and circumstances:
Type of arrangement Included in the inventory of:

 Goods in transit
a. FOB shipping point Buyer
b. FOB destination Seller
 Consigned goods Consignor
 Inventory financing agreement Borrower
 Sale with unusual right of return Buyer (except when unsalable)
• Sale on trial or sale on approval Seller
 Installment sale Buyer
 Bill and hold sale Buyer
 Lay away sale Seller
Transactions affecting inventories:
Effect
Purchases increase
Purchase returns decrease
Received from consignors no effect
Transferred to consignees no effect
Sales decrease
Sales–received from consignors no effect
Sales – consignees decrease
Sales returns–in good condition increase
Sales returns-unsalable no effect
Periodic inventory system – the information is available at the end of each period after
the entity has conducted physical count of the goods.

Perpetual inventory system – the information is readily available from the perpetual
records, which is automatically updated for transactions affecting inventories.
Recognition
Applies the general recognition criteria for the elements of financial statements.

Measurement
In accordance with PAS 2, inventories are required to be measured at lower of cost and net
realizable value (NRV).

Items included in cost

• Costs of purchase
a) the purchase price
b) import duties and non-refundable purchase taxes
c) transport, handling and other costs directly attributable to the acquisition of
finished goods, materials and services.
Trade discounts, rebates and other similar items are deducted in determining the costs of
purchase.
• Costs of conversion – costs incurred to convert materials into finished goods.
Examples of production (factory) overhead include:
a) depreciation and maintenance of factory building, equipment and right-of
use- assets used in the production process
b) cost of factory management and administration
c) indirect materials
d) indirect labor
• 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.
Goods in process, including OH 100%
Less: OH -20%
Goods in process, excluding OH 80%

Goods in process (720,000 ÷ 80%) = 900,000

Sales 750,000 ÷ 150% = 500,000

Less: Cost of sales 500,000 100%
Gross Profit 250,000 50%
Items not included in cost
• Unallocated overheads
• Abnormal amount of wasted materials, labor, or other production costs
• Storage costs
• Administrative overheads
• Selling expenses
• Foreign exchange differences

Recognition as expense
• The carrying amount of inventories when inventories are sold
• The amount of any write-down of inventories to NRV
• All losses of inventories
Chapter 11:
Cost formulas:
Specific identification of cost means that specific costs are attributed to identified inventory.
units on hand x specific unit cost

FIFO - items of inventory that were purchased or produced first are sold first.
units on hand x unit cost of latest purchases

Weighted average – the cost of each item is determined from the weighted average of the
cost of similar items at the beginning of a period and the cost of similar items purchased or
produced during the period.
units on hand x weighted average unit cost (wauc)
Illustration 1.1 - Cost formulas:
Illustration 1.1 - Cost formulas:
Required: Determine the cost of inventory as of June 30 and COS for the month of June using:
1. Specific identification assuming 600 units came from June 3 purchases
2. FIFO, periodic
3. FIFO, perpetual
4. Weighted average, periodic
5. Weighted average, perpetual (moving average)

Solution 1 – Specific Identification

Cost of June 30 inventory (600 units x P3.10) = P1,860
Cost of sales:
TGAS P10,605
Less inventory, June 30 1,860
COS P 8,745
Solution 2 – FIFO, periodic
Cost of June 30 inventory:
Cost of inventory June 22 (250 units x P3.50) P 875
Cost of inventory June 15 (350 units x P3.40) 1,190
600 P2,065
Cost of sales:
TGAS P10,605
Less inventory, June 30 2,065
COS P 8,540
Solution 3 – FIFO, perpetual
Solution 4 – weighted average, periodic
Weighted average unit cost:
Total goods available for sale P10,605
Divide by total units available for sale 3,250
P 3.26/unit cost
Cost of inventory, June 30 (600 units x P3.26) = P1,956
Cost of sales:
TGAS P10,605
Less inventory, June 30 1,956
COS P 8,649
Solution 5 – moving average
Chapter 12: LOWER OF COST AND NET REALIZABLE VALUE (LCNRV)
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 necessary to make the
sale. Estimated SP xx
Write-down to NRV Less: Estimated cost of disposal xx
• Damaged inventories Estimated cost to complete xx
• Obsolete inventories NRV xx
• Declined in selling price
• Increased in the estimated costs to complete or costs to be incurred to make the sale
Item Cost NRV
P P100,000 P 80,000
R 200,000 210,000
T 300,000 270,000
C 400,000 425,000
Total 1,000,000 985,000
 Item LCNRV Loss
P P 80,000 P 20,000
R 200,000 ----------
T 270,000 30,000
C 400,000 ----------
Total 950,000 50,000
J.E. to recognize the write-down using allowance method:
Loss on write-down to NRV 50,000 (added to COS)
Allowance for write-down to NRV 50,000 (deducted from inv. acct.)
Cost of sales under the 2 methods:
Allowance Direct
TGAS (assumed amt) 8,000,000 8,000,000
Inventory, end (1,000,000) ( 950,000) LCNRV
Cost of sales 7,000,000 7,050,000
Add: Loss on write down 50,000
Total cost of sales 7,050,000 7,050,000

Direct Method: Allowance Method:

Ending inventory 950,000 Ending inventory 1,000,000
Income summary 950,000 Income summary 1,000,000

Loss on write-down 50,000

Allowance on inventory writedown 50,000
Direct Method:
F/S Presentation:
Inventory – P950,000

Allowance Method:
F/S Presentation:
Inventory, at cost P1,000,000
Less: Allowance for inventory write-down 50,000
NRV P 950,000
Reversal of Write-down to NRV:
Illustration using the same info in the previous example but there is an existing allowance
for write-down to NRV of P70,000.
Total cost P1,000,000
Inventory at the lower of cost and NRV (950,000) (LCNRV)
Required allowance for write-down to NRV 50,000
Recorded allowance for write-down to NRV 70,000
Increase (decrease) in allowance ( 20,000)

Journal entry to recognize the reversal of write-down:

Allowance for write-down to NRV 20,000
Reversal of write-down to NRV 20,000
Other topics: Accounting for discounts
Trade discounts:
• given to encourage buying in large quantities
• quantity discounts
• stated in percentage form
• deducted from the list price to arrive at invoice price
List price xxx
Less: Trade discounts xxx
Invoice price xxx (for recording in the books)
• not recognized for financial accounting purposes
• A/P is recorded net of trade discounts
Other topics: Accounting for discounts
Cash discounts:
 given to encourage buyers for prompt payment of account.
 early payment discount
 stated in terms as follows;
2/10 1/15 n/30 – 2% discount is given if the account is paid within 10 days from
the invoice date, 1% discount is given if the account is paid within 15 days, gross amount
is due in 30 days from the invoice date.

Cash discounts methods of accounting:

1) Gross method
• purchases and A/P are recorded at gross invoice amount (cash discount is not yet
deducted from the invoice price)
• cash discounts are recognized only when actually taken by the buyer
Cash discounts methods of accounting:
2) Net method
• purchases and A/P are recorded at an amount net of cash discount
• cash discounts not taken by the buyer is debited to the purchase discount lost
account, which is included under finance cost or interest expense in the
comprehensive income statement
Illustration: .80 x .90 = .72 x 10,000 = 7,200
An entity purchased inventory with a list price of P10,000 on account under credit terms
of 20%, 10%, 2/10, 1/15, n/45.
Requirements:
1. Prepare the J/E using the gross method under the periodic and perpetual inventory
system; A) the account was paid on day 10; b) the account was paid on day 15; c) the
account was paid on day 45.
2. Prepare the J/E using the net method under the periodic and perpetual inventory
system; A) the account was paid on day 10; b) the account was paid on day 15; c) the
account was paid on day 45.
Purchase Commitments (PC)
• Refers to an entity’s commitment to purchase specified commodities at a
predetermined price and quantity at a future date (with purchase contract).
• PC protects business from price increase (PC can either be cancellable or non-
cancellable).
• Necessary disclosure in the notes for significant and unusual PC.
• Any estimated losses resulting from firm and noncancellable commitments must be
recognized. A loss is recorded in the period of the price reduction if the purchase price
falls after a purchase commitment has been made.
• If the purchase price falls below the agreed price at the end of the reporting period,
the J/E is; (this applies to non-cancellable purchase commitments)
Loss on purchase commitments xxx
Estimated liability for purchase commitment xxx
• In the event of market price recovery, gain on purchase commitment is recognized up
to the extent of previously recognized loss on purchase commitment.
Illustration:
The contract price is P700K and the market price at year end is P620K. The market decline
P80K, to be recorded as follows;
Classified as;
Other expense - Loss on purchase commitment 80,000
Current liability - Estimated liability for purchase commitment 80,000
When the actual purchase price is made in the subsequent period and the current
replacement cost drops further to P600K, the J/E will be;
Purchases 600,000
Loss on purchase commitment 20,000
Estimated liability on PC 80,000
Accounts Payable 700,000

Note: recognizing a loss on purchase commitment applies the LC or NRV measurement

If the market price increases by the time the entity makes the purchase, the entity will
report a gain on the PC. The gain, however, is up to amount of loss recognized previously.
In the preceding illustration, if the PC market price is P800K when the actual purchase is
made, the J/E will;
Purchases* 700,000
Classified as; Estimated liability on PC 80,000
Accounts Payable 700,000
Other income Gain on purchase commitment 80,000

Note: *The PC of P700K is less than the MV of P800K, the purchases is booked at P700K.
If the market price of the PC is P680K when the actual purchase is made, the J/E will be;

Purchases 680,000
Estimated liability on PC 80,000
Accounts Payable 700,000
Gain on purchase commitment 60,000

Note:
• the purchases is booked at P680K because the replacement cost is lower than the PC of
P700K.
• the gain on PC is the increase in market price from P620K at year end to P680K on the
date of actual purchase.
References:
Millan, ZV. B. (2020). Intermediate Accounting 1A & 1B. Baguio City: Bandolin Enterprise
Publishing
Ocampo, R. R. (2022). Intermediate Accounting Volume 1. Manila: DomDane Publishers
Robles, N. S., Empleo, P. M. (2022). The Intermediate Accounting Volume 2. Quezon City: EDT
Book Publishing.

Valix, C. T. , Peralta, J. F., Valix C.A. M., (2021). Intermediate Accounting Volume 1.
Manila: GIC Enterprises & Co., Inc.

Villaluz, BC. S., Cruz, MS. M. (2022). Financial Accounting and Reporting. Cainta, Rizal:
BCV Accounting Bookshop