INVENTORIES (IAS 2)

Definition

Inventories are assets:

a. held for sale in the ordinary course of business;
b. in the process of production for such sale; or
c. in the form of materials or supplies to be consumed in the production
process or in the rendering of services.

Inventories encompass
a. goods purchased and held for resale
b. finished goods produced
c. work in progress being produced
d. materials and supplies used in the production process
e. in the case of a service provider, the cost of the service for which the
enterprise has not yet recognized the related revenue.

Recognition and Ownership of Inventories

• Inventories are recorded as assets and are reported on the balance
sheet when the following conditions are met:
• It is probable that the future economic benefits are associated with
the inventories will flow to the enterprise.
• The inventories have cost or value that can be measured reliably.

Cost of Inventories
1. Cost of purchase
• Include purchase price, import duties and taxes, freight,
handling and other cost
• Net of trade discounts and rebates.

2. Cost of conversion
• Include cost directly related to the units of production (ex: direct
labor, allocation of fixed and variable production overhead)
• Fixed production overhead – indirect costs of production that
remains relatively constant regardless of the volume of
production.
• Variable production overhead – indirect costs of production that
vary directly with the volume of production.

3. Other costs
• Costs incurred in bringing the inventories to their present
location and condition.
• The following are excluded from the cost of inventories and are
recognized as expenses:
 Abnormal amounts of wasted
materials, labor and other
production cost

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  Storage costs not unless these
are necessary in the production
process prior to a further
production stage
 Administrative overheads that
do not contribute to bringing
inventories to their present
location and condition.
 Selling cost

Cost of Inventories of a Service Provider

1. Labor and other costs of personnel directly engaged in providing the
service including supervisory personnel and attributable overhead
2. Costs relating to sales and general administrative personnel are not
included but are recognized as expenses.

Items Included in Inventory Quantities

 The basic criterion is economic control rather than physical
possession.
 Purchases should be recorded when legal title passes to the
buyer.

1. Goods in transit
• FOB Shipping Point – legal title to (and control
of) the goods is transferred at the shipping point
when the seller delivers them to the shipping
company.
• FOB Destination Point – legal title (and control) is
not transferred until the goods are delivered to
the buyer’s place
• Summary
Terms of Shipment Seller Buyer

FOB Shipping Point Exclude Include

FOB Destination Point Include Exclude

2. Consigned goods
• Consignment is a special marketing arrangement wherein the
consignee acts as the agent in charge of selling the goods.
• Goods out on consignment remain the property of the consignor.

3. Sales with buyback agreements

• Also referred to as parking transaction and product financing
arrangement.
• A business sells its inventory and agrees to repurchase the
merchandise at a specified price over a specified period.
 • Inventory remains in the books of the seller. No sale is recorded.

4. Sales on installments
• A type of sale in which payment is required in periodic
installments over an extended period of time.
• Goods sold on an installment basis are excluded from the seller’s
inventory.

5. Segregated goods
• Pertains to special order goods manufactured according to
customer’s specifications.
• If goods are produced on special customer order, they may be
recorded as a sale as soon as they are completed and
segregated from the regular inventory. If the sale is recognized
upon segregation by the seller, the goods shall be excluded from
the seller’s inventory. The buyer could recognize the goods as
part of inventory (Skousen).
• These are excluded from seller’s inventory (even if it is still in the
possession of the seller).

6. Sales with High Rate of Return

• When sales returns can be reasonably estimated, it should
consider the goods sold and should remove the goods from
inventory.
• When sales returns are unpredictable, it should not consider the
goods sold and it should not remove the goods from inventory.

7. Goods out on approval

• Goods are owned by the seller until approved by the customer.

Cash discounts
Cash discounts are reductions in invoice price of purchases resulting from
payment of accounts within the discount period. The objective of the
seller in offering the discounts is to encourage early payment of accounts
by the buyer.

Recording of Purchases
Purchases may be recorded at gross invoice price (gross method) or at
gross invoice price less available cash discounts (net method).

• Under the gross method, cash discounts are recorded only when
availed by the company and are credited to the account “Purchases
Discounts” or “Inventory”. Cash discounts that were not availed are
not reflected in the records. The Purchases Discounts account is
reported in the income statement as a deduction from gross
purchases.

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 • Under the net method, cash discounts are immediately deducted from
the gross invoice price. The “Purchases” account or “Inventory”
account is debited for the net invoice price upon purchase of the
goods. If payment of account is made after the discount period; the
account “Purchase Discount Lost” is debited for the amount of
discounts lost. The amount of discounts availed is not reflected in the
records. The Purchase Discounts Lost account is reported in
the income statement as finance cost.

Inventory Accounting Systems

1. Periodic System

 Also called the physical system

 Does not maintain continuous record of the physical quantities
(or costs) of inventory on hand
 Physical count is taken at least once a year.
 Uses the account titles: Purchases, Purchase Discounts, Purchase
Returns and Allowances, and Freight-in.

2. Perpetual System

 Maintains continuous records (detailed subsidiary records) of the

movement of the items in the inventory.
 Uses the account titles Merchandise Inventory and Cost of Goods
Sold
 A physical count is made at least once a year to confirm the
inventory balance per books
 Makes use of the account Inventory Over and Short to reconcile
the difference between inventory balance and the physical
count.
 The Inventory Over and Short 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 should be separately
classified and presented as other expense.

Pro-forma Entries

Periodic
Perpetual
Purchases xx Merchandise Inventory xx
x x
Cash/Accounts Payable xx Cash/Accounts Payable xxx
x
Purchase of merchandise Purchase of merchandise
Accounts Payable/Cash xx Accounts Payable/Cash xx
x x
Purchase Returns & xx Merchandise Inventory xxx
Allowances x
Return of merchandise to seller Return of merchandise to
seller

Accounts Payable xx Accounts Payable xx

x x
Purchase Discount xx Merchandise Inventory xxx
x
Cash xx Cash
x
Full payment within the discount Full payment within discount
period period

Freight-in xx Merchandise Inventory xx

x x
Cash xx Cash xxx
x
Buyer pays freight: FOB SP, Buyer pays freight: FOB SP,
collect collect

Accounts Receivable/Cash xx Accounts xx

x Receivable/Cash x
Sales xx Sales xxx
x
Sale of merchandise

Cost of Goods Sold xx

x
Merchandise Inventory xxx
Sale of merchandise

Sales Returns & Allowances xx Sales Returns & xx

x Allowances x
Accounts Receivable xx Accounts Receivable xxx
x
Return of merchandise by
customer as recorded by seller
Merchandise Inventory xx
x
Cost of Goods Sold xxx

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 Return of merchandise by
customer as recorded by
seller

Cost Methods
1. Specific identification
 Specific costs are attributed to identified items of inventory
 Applicable for inventory with a small number and are easily
distinguishable.
 Makes possible to manipulate net income

2. Average cost
 Considers goods to be indistinguishable
 Goods are valued at an average of the costs incurred.
 Weighted average (periodic system) and moving average
(perpetual system).

3. FIFO (First in First out)

 The first goods purchased are first sold.
 Ending inventory is presumed to consist of the most recent costs.
 There is no proper matching of costs and revenues since old
costs are matched against current revenues.
 Favors the balance sheet because ending inventory
approximates replacement costs.

Valuation of Inventory

1. Inventories shall be measured at the lower of cost or net realizable

value.
 Net realizable value – 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.
2. The cost of inventories should be determined by using either the FIFO
method or weighted average method. The new standards prohibit the
use of LIFO inventory costing.
3. The cost of inventories that are not ordinarily interchangeable and
inventories that are segregated for specific projects should be
determined by using specific identification method.

Lower of Cost or Net Realizable Value

1. Inventories are recorded at their original cost.
2. Inventories decline in value below its cost.
3. Reasons for the decline:
• Obsolescence
• Price level changes
• Damaged goods
4. Inventory should be written down to reflect the loss.
5. Inventories that experience a decline in value shall be measured at
lower of cost or net realizable value.
6. Cost is the acquisition price of inventory.
7. Net Realizable Value (NRV) = Estimated Selling Price - Estimated Cost
of Completion and Disposal
8. Lower of cost or net realizable value is applied on an item by item
basis or individual basis.
• LCNRV can be consistently applied to batches of a product using
a FIFO or weighted average cost flow assumptions, or groups of
similar products.
• It is not appropriate to write inventories down on the basis of a
classification of inventory, for example, finished goods, or all the
inventories in a particular industry or geographical segment.
9. LCNRV is consistent with the Doctrine of Conservatism
10. Inventories of materials and supplies held for use in the
production process are not written down below cost if the finished
goods in which they are expected to be incorporated are expected to
be sold at or above cost.
11. Only when the sale of finished goods is not expected to recover
the costs are the materials and supplies written down to their net
realizable value.

Observations:

The lower of cost and NRV rule suffers some conceptual deficiencies:

 Decreases in the value of the asset and the charge to expense are
recognized in the period in which the loss in utility occurs, not in the
period of sale. On the other hand, increases in the value of the asset
are recognized only at the point of sale. This treatment is inconsistent
and can lead to distortions in income data.

 Application of the rule results in inconsistency because the inventory of

an entity may be valued at cost in one year and at net realizable value
in the next year.

 Lower of cost and NRV values the inventory in the balance sheet
conservatively, but its effect on the income statement may or may not
be conservative. Profit for the year in which the loss is taken is
definitely lower. Profit of the subsequent period may be higher than
normal if the expected reductions in sales price do not materialize.

 The standard allows professional judgment. This is likely to lead to

variation between companies in their implementation of the standard.
Further the need for professional judgment presents an opportunity for
profit manipulation.

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Pro-forma Entries

Allowance Method Direct

Method
Periodic Method

Merchandise Inventory xx Merchandise xx

x Inventory x
Income Summary xx Income Summary xxx
x

Loss on Inventory Writedown xx

x
Allowance for Inventory xx
Writedown x

Perpetual Method

Loss on inventory Writedown xx Cost of Goods Sold xx

x x
Allowance for Inventory xx Merchandise xxx
Writedown x Inventory

For recoveries:
Allowance for Inventory Writedown xx
x
Gain on Inventory xx
Recovery* x

*Gain is limited only up to the extent of the allowance balance

Financial Statement Presentation

Loss on Inventory Writedown Added to cost of goods sold

Gain on Inventory Recovery Deducted from cost of goods sold

Allowance for Inventory Contra account, deducted from

Writedown Merchandise Inventory
Disclosures

1.The accounting policies adopted in measuring inventories

including the cost method used.
2.The total carrying amount of inventories and the carrying
amount in classifications appropriate to the enterprise.
3.The carrying amount of inventories at net realizable value.
4.The amount of reversal of any write-down that is recognized as
income.
5.The circumstances or events that led to the reversal of a write-
down of inventories.
6.The carrying amount of inventories pledged as security for
liabilities.
7.The amount of inventories recognized as an expense during
the period.

Inventory Estimation Techniques

Inventory estimation techniques are necessary when -

 It is too costly to conduct a physical count (as in the case

for interim reports).
 It is no longer possible to physically count the inventory
like when the goods are destroyed by a natural disaster.

Two Estimation Techniques

 Gross Profit Method or Gross Margin Method

Gross profit may be expressed as
• a percentage of sales – gross profit / sales
• a percentage of cost of goods sold – gross profit / cost of
goods sold

It is useful in the following instances:

• In determining inventory amount to be reported in the interim
financial statements.
• In determining the amount of inventory loss caused by
casualty such as fire and flood.
• In determining the reasonableness of inventory figures
determined by the other means (gross profit test).
• It is not acceptable in determining inventory amount to be
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 reported in the year-end financial statements.

 Retail Inventory Method

• Based on an assumed relationship between cost and price
• Widely used by retail stores
• Records are maintained at two amounts – cost and retail.

Steps under the Gross Profit Method

1. Compute for cost of goods available for sale.

2. Apply gross profit to compute for cost of goods sold.
3. Subtract cost of goods sold from cost of goods available for
sale.

Beginning inventory P xxx

Add: Net cost of purchases xxx

Cost of goods available for sale P xxx

Less: Estimated cost of goods sold

(a) GPR is based on sales : Net sales x (100% - GPR) --- Cost
Ratio
(b) GPR is based on cost : Net sales / (100% + GPR) --- Sales xxx
Ratio
Estimated cost of ending inventory P xxx

The cost of inventories may not be recoverable if

 they are damaged
 they have become wholly or partially obsolete
 their selling prices have declined
 the estimated costs of completion or the estimated costs to be
incurred to make the sale have increased

Estimates of net realizable value are based on

 the most reliable evidence available at the time the estimates
are made as to the amount the inventories are expected to
realize
 the purpose for which the inventory is held
 The NRV of the quantity of inventory held to satisfy firm sales
or service contracts is based on the contract price.

If there are undamaged or partially damaged merchandise, computation of

inventory loss is as follows:

Estimated cost of ending inventory P xxx

 Less: Cost of undamaged merchandise P xxx

Realizable value of partially

damaged inventory (but not to
exceed cost) xxx xxx

Estimated inventory loss P xxx

Terms Used Under the Retail Inventory Method

1. Original retail – initial sales price

2. Initial mark-up – the original increase over cost
3. Additional mark-up – an increase in the original retail price
4. Mark-up cancellations – decreases additional markups that do
not reduce sales prices below original retail
5. Net markups – additional markups less markup cancellations
6. Markdowns – decreases that reduce sales price below original
retail
7. Markdown cancellations – decreases in the markdowns that do
not raise the sales prices above original retail.
8. Net markdowns – markdowns less markdown cancellations.

Steps under the Retail Inventory Method

1. Compute for CGAS at cost and

at retail
2. Compute the cost to retail ratio
(CGAS at cost/CGAS at retail)
3. Deduct sales from CGAS at
retail to arrive at estimated
ending inventory
4. Apply the cost to retail ratio to
ending inventory at retail to
arrive at estimated ending
inventory at cost.

Types of Retail Inventory Method

1. Conventional/ Lower of Cost or Market

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 2. Average Cost
Section 22 of IAS 2: The percentage used takes into
consideration inventory that has been marked down to
below its original selling price. An average percentage
for each retail department is often used.

3. FIFO

• Under the conventional and average cost

method, the cost percentage is computed
as follows:
Goods available for sale (GAS), at cost
Goods available for sale (GAS), at retail

• Under FIFO method, beginning inventories

are not included in the calculation of cost
percentage. Thus, the cost percentage is
computed as follows:
GAS, at cost – Beginning inventory
GAS, at retail – Beginning inventory

Average Retail Inventory Method

Cost Retail

Beginning inventory P xxx P xxx

Purchases xxx Xxx

Purchase returns (xxx) (xxx)

Purchase discounts (xxx)

Purchase allowance (xxx)

Freight in xxx

Net markup xxx

Net markdowns (xxx)

Abnormal losses (xxx) (xxx)

Departmental transfers in or debit xxx xxx

Departmental transfers out or credit (xxx) (xxx)

Goods available for sale P P

xxx xxx

Cost to retail ratio

Net sales (sales less sales returns) (xxx)

Employee discounts (xxx)

Normal losses (inventory shortage, spoilage, breakage) (xxx)

Estimated ending inventory, retail P

xxx

Estimated ending inventory, cost (estimated ending

inventory, retail x cost to retail ratio) xxx
Estimated cost of goods sold P
xxx

Summary (in computing the cost to retail rate)

Conventional Average FIFO

Beginning inventory Include Include Exclude

Net markups Include Include Include

Net markdowns Exclude Include Include

Special Notes: Computation of Net Sales When Estimating Ending

Inventory
1. For purposes of estimating ending inventory, sales allowances and sales
discounts are ignored when computing net sales. Sales allowance and
sales discount do not affect the physical inventory of goods. These are
mere reductions in the sales price.

2. For purposes of estimating ending inventory, sales returns is deducted

from gross sales when computing net sales. Sales returns cause an
actual addition to goods on hand.

3. When the account is Sales Returns and Allowances, this is deducted from
gross sales to arrive at net sales.

Purchase Commitments

 Contracts made for the future purchase of goods at fixed

prices
 Arrangements are made on the basis of estimated sales
(commitments form customers)
 Title to merchandise has not passed to the buyer.
 Not necessary for the buyer to make any entry

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  No asset or liability is recognized.
 Must be disclosed.
 It is an executory contract whereby the company commits
itself to purchase a specified predetermined price and at a
specified future date.
 No journal entry is required to record the commitment
made by the enterprise.
 When the price of the goods increases as at balance sheet
date and prior to the delivery date of the goods, the
increase is not recognized. Hence, no journal entry is
made.
 When the price of the goods decreases as at balance sheet
date and prior to the delivery date of goods, the decline is
accounted for as follows:
 If the contract is cancelable or the price is subject to
adjustment, the decline is not recognized.
 If the contract is non-cancellable and the price is not
subject to adjustment, the decline is recognized as a loss
and a liability is recorded for the amount of the loss.
 When there is a full or partial recovery of the purchase
price, the recovery would be recognized as a gain in the
period during which the recovery takes place.
 Recovery of loss on purchase commitments is reported on
the income statement as other income.
 The amount of recovery that is taken up, however, is
limited to the loss recorded in the previous period for the
same purchase commitment.

Estimated Loss on Purchase Commitments xxx

Estimated Liability on Purchase Commitment xxx

Purchases xxx

Estimated Liability on Purchase Commitment xxx

Cash/Accounts Payable xxx

RELATIVE SALES PRICE METHOD

 Different commodities are purchased at a single cost or lump sum
amount.
 The single cost is apportioned among the commodities based on their
respective sales price.
 This is based on the philosophy that cost is proportional to selling
price.
BORROWING COSTS
 Borrowing cost includes the following:
 Interest on short-term and long-term borrowing
 Amortization of discount or premium related to borrowing
 Amortization of ancillary cost incurred in connection with the
arrangement of borrowing
 Finance charge with respect to finance lease
 Exchange difference arising from foreign currency borrowing to
the extent that it is regarded as an adjustment to interest cost

 If the borrowing is directly attributable to the acquisition, construction

or production of qualifying asset, the borrowing cost is required to be
capitalized as cost of the asset. In other words, the capitalization of
borrowing cost is mandatory for a qualifying asset.

 All other borrowing costs shall be expensed as incurred. In other

words, if the borrowing is not directly attributable to a qualifying asset,
the borrowing cost is expensed immediately.

 A qualifying asset is an asset that necessarily takes a substantial

period of time to get ready for its intended use or sale

Examples
1. Manufacturing plants
2. Power generation facilities
3. Investment properties

 A qualifying asset includes inventories that require a substantial period

of time to bring them to a salable condition

 Excluded from capitalization

a. Assets measured at fair value, such as biological assets
b. Inventories that are manufactured or produced in large
quantities on a repetitive basis, such as manufacturing whisky,
even if they take a substantial period of time to get ready for
sale

INVENTORIES VALUED AT SELLING PRICE

 In exceptional cases, inventories may be reported at fair value less
disposal costs

Fair value – It is the amount for which an asset could be exchanged,

or a liability settled, between knowledgeable and willing parties in an
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 arm’s length transaction.

 The following are the justification for the treatment:

 When cost is difficult to determine
 Quoted market price are available
 Marketability is assured
 Units are interchangeable

 The following are the application of this valuation:

 Cost of Agricultural Produce Harvested from Biological
Assets. Inventories comprising agricultural produce that an
entity has harvested from its biological assets are measured on
initial recognition at their fair value less estimated point of sale
costs at the point of harvest.

 Commodities of broker traders.

It is measured at fair value less cost to sell. Broker traders are
those who buy and sell commodities for others or on their own
account. The inventories of broker traders are principally
acquired with the purpose of selling them in the near future and
generating a profit from fluctuations in price or broker-traders’
margin.

Note: Both the inventories above are excluded from PAS 2.

USE OF MORE THAN ONE COST METHOD

 In practice, many reporting enterprises have used different methods;
for example – FIFO for raw materials and weighted average for work in
process and finished goods.
 PAS 2 requires that similar inventories must be given costed by the
same method.
 Inventories used in similar fashion by a given entity, even differently
sited or managed operation of a given enterprise should be costed by
the same formula or method.
 It has held that different cost of formulae for different types of
inventories, for inventories having different nature and uses, different
cost formulae could be justified.
 Inventories having the same characteristics should be valued by
means of the same cost formulae.
 Disclosure should be made of the accounting methods used in any
event.

June 2012