Inventory

FINANCIAL ACCOUNTING VOLUME 1

6:30 – 7:30
PAS 2, paragraph 6 defines inventories as follows:

 Inventories are 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 services.
 Inventories encompasses good purchased and held for resale, for example, merchandise
purchased by a retailer and held for resale, or land and other property held for resale by a
subdivision entity and real estate developer.

 Inventories also encompasses finished goods produced, good in process and materials and
supplies awaiting use in the production process.

 In case of service provider, inventories include the cost of the service for which the entity
has not yet recognized the related revenue.

 The cost of service consists primarily of the labor and other cost of personnel directly
engaged in providing the service including supervisory personnel and attributable
overhead.
Classes of inventories

 Inventory of trading concern – is one that buys and sells goods in the same form
purchased. The term “merchandise inventory” is generally applied to goods held
by a trading concern.

 Inventory of manufacturing concern – is one that buys goods which are altered or
converted into another form before they are made available for sale.

 The term “finished goods”, “goods in process”, “raw materials” and “factory or
manufacturing supplies” refer to inventories of a manufacturing concern.
 Finished goods are completed products which are ready for sale.
Finished goods have been assigned their full share of manufacturing costs.

 Goods in process or work in process are partially completed products which

require further or work before they can be sold.

 Raw materials are goods that are to be used in the production process. No work
or process has been done on them as yet by the entity inventorying them.
Materials that will be physically incorporated in the production of other goods
and which can be traced directly to the end product of the production process.

 Factory or manufacturing supplies are similar to raw materials but their

relationship to the end product is indirect. These supplies may be referred to as
indirect materials. It is indirect because they are not physically incorporated in
the products being manufactured.
Goods includible in the inventory
All goods to which the entity has title shall be included in the inventory, regardless of
location. Where title has already passed from the seller to the buyer, the goods form part of
the inventory of the seller.
“Passing 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.
If the answer is in the negative, the goods shall be excluded from the inventory.
Applying the legal test, goods owned and on hand, goods in transit and sold FOB
destination, goods in transit and purchased FOB shipping point, goods out on consignment,
goods in the hands of salesmen or agents, goods held by customers on approval or on trial
are all includible in inventory.
Exception to the legal test

 Installment contracts may provide for retention of title by the seller until the
selling price is fully collected.

 The goods on installment basis are still the property of the seller and therefore
normally includible in his inventory.

 However, in such a case, it is an accepted accounting procedure to record the

installment sale as a regular sale involving deferred income on the part of the
seller and as a regular purchase on the part of the buyer.

 Thus, the goods sold on installment are included in the inventory of the buyer and
excluded from that of the seller, the legal test to the contrary notwithstanding.

 This is an example of economic substance prevailing over the legal form.

Who is the owner of the goods in transit?

FOB destination – ownership of goods purchased is transferred only upon receipt of the goods
by the buyer at the point of destination. The goods in transit are still the property of the seller.

The seller shall legally be responsible for the freight charges and other expenses up to the point
of destination.

FOB shipping point – ownership is transferred upon shipment of the goods and therefore, the
goods in transit are property of the buyer.

The buyer shall legally be responsible for freight charges and other expenses from the point of
shipment to the point of destination.

In practice, during an accounting period, the accountant normally records purchases when
goods are received and sales when goods are shipped, regardless of the precise moment at
which the title passed.
Freight Terms

 Freight collect – means that 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 – means that freight charge on the goods shipped is already paid by
the seller.
 The terms “FOB Destination” and “FOB Shipping Point” determined ownership of
the goods in transit and party who is supposed to pay the freight charge and other
expenses from the point of shipment to the point of destination.

 The terms “freight collect” and “freight prepaid” determine the party who actually
paid the freight charge but not the party who is supposed to legally pay the freight
charge.
Maritime shipping terms

 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 alongside the vessel on
which the goods are to be shipped. The buyer bears the cost of loading and
shipment and thus title passes to the buyer when the carrier takes possession of
the goods.

 CIF or Cost, insurance and freight – under the shipping contract, the buyer
agrees to pay in a lump sum the cost of the goods, insurance cost and freight
charge. The shipping contract may be modified as CF which means that the
buyer agrees to pay in a lump sum the cost of the goods and freight charge
only.
Maritime shipping terms

 In either case, the seller must pay for the cost of loading. Thus, title and risk of
loss shall pass to the buyer upon delivery of the goods to the carrier.

 Ex –ship – a seller who delivers the goods ex-ship bears all expenses and risk
of loss until the goods are unloaded at which time title and risk of loss shall
pass to the buyer.
Consigned goods

 A consignment is a method of marketing goods in which the owner called the

consignor transfers physical possession of certain goods to an agent called the
consignee who sells them on the owner’s behalf.

 Consigned goods shall be included in the consignor’s inventory and excluded from
the consignee’s inventory.

 Freight and other handling charges on goods out on consignment are part of the cost
of goods consigned.

 When consigned goods are sold by the consignee, a report is made to the consignor
together with a cash remittance for the amount of sales minus commission and other
expenses chargeable to the consignor.
For example, a consignee sells consigned goods for P100,000. This amount is
remitted to the consignor less commission of P15,000 and advertising of P2,000.

The consignor simply records the cash remittance from the consignee as follows:

Cash 83,000
Commission 15,000
Advertising 2,000
Sales 100,000

Incidentally, consigned goods are recorded by the consignor by means of a

memorandum entry.
Accounting for inventories

Periodic System - calls for the physical counting of goods on hand at the end of
the accounting period to determine quantities.

The quantities are then multiplied by the corresponding unit costs to get the
inventory value for balance sheet purposes. This approach gives actual or
physical inventories.

The periodic inventory procedure is generally used when the individual inventory
items have small peso investment, such as groceries, hardware and auto parts.
 Perpetual systems – requires the maintenance of records called stock cards
that usually offer a running summary of the inventory inflow and outflow.
 Inventory increases and decreases are reflected in the stock cards and the
resulting balance represents the inventory. This approach gives book or
perpetual inventories.

 The perpetual inventory procedure is commonly used where the inventory

items treated individually represent a relatively large peso investments such as
jewelry and cars.
 When the perpetual system is used, a physical count of the units on hand
should be at least be made once a year or at frequent intervals to confirm the
balances appearing on the stock cards.
Illustration – Periodic system

 Purchase of merchandise on account, P300,000

Purchases 300,000
Accounts payable 300,000

 Payment of freight on the purchase, P20,000

Freight in 20,000
Cash 20,000

 Return of merchandise purchased to supplier, P30,000

Accounts payable 30,000

Purchase return 30,000
 Sale of merchandise sold from customer, P25,000.

Sales return 25,000

Accounts receivable 25,000

 Adjustment of ending inventory, P65,000

Merchandise inventory –end 65,000

Income summary 65,000
Illustration – Perpetual System

 Purchase of merchandise on account, P300,000

Merchandise inventory 300,000

Accounts payable 300,000

 Payment of freight on the purchase, P20,000

Merchandise inventory 20,000

Cash 20,000

 Return of merchandise purchased to supplier, P30,000

Accounts payable 30,000

Merchandise inventory 30,000
 Sale of merchandise on account, P400,000 at gross profit of 40%. The cost of
merchandise sold is 60% or P240,0000.
Accounts receivable 400,000
Sales 400,000
Cost of goods sold 240,000
Merchandise inventory 240,000

Under the perpetual system, the cost of merchandise sold is immediately

recorded because this is clearly determinable from the stock card.
 Return of merchandise sold from customer, P25,000. The cost of the
merchandise returned is 60% or P15,000.
Sales return 25,000
Accounts receivable 25,000
Merchandise inventory 15,000
Cost of goods sold 15,000

 Adjustment of ending inventory

As a rule, the ending merchandise inventory is not adjusted. The balance of the
merchandise inventory account represents the ending inventory.
Inventory shortage or overage
In the illustration, the merchandise inventory account has a debit balance of P65,000.
If at the end of the accounting period, a physical count indicates a different amount,
an adjustment is necessary to recognize any inventory shortage or overage.
If the physical count shows inventory on hand of P55,000 the following adjustment is
necessary:
Inventory shortage 10,000
Merchandise inventory (65,000-55,000) 10,000
The inventory shortage is usually closed to COST OF GOODS SOLD because this is
often result of normal shrinkage and breakage in inventory.
Abnormal and material shortage shall be separately classified and presented as other
expense.
Trade discounts and cash discounts

 Trade discounts – deductions from the list or catalog price in order to arrive at the invoice
price which is the amount actually charged to the buyer. Thus, trade discounts are not
recorded.

 The purpose of trade discounts is to encourage trading or increase sales. Trade discounts
also suggest to the buyer the price at which the goods may be resold.
 Cash discounts – deductions from the invoice price when payment is made within the
discount period. The purpose of cash discounts is to encourage prompt payment.

 Cash discounts are recorded as purchase discount by the buyer and sales discount by the
seller.

Purchase discount - deducted from the purchases to arrive at the net purchases
Sales discount - deducted from the sales to arrive at the net sales revenue
Illustration:

The list price of a merchandise purchased is P500,000 less 20% and 10% with credit terms of
5/10, n/30.
This means that trade discounts are 20% and 10% and the cash discounts is 5% if payment is
made in 10 days.
The full amount of the invoice is paid if the payment is made after 10 days and within the
credit period of 30 days.
List price 500,000
First trade discount (20% X 500,000) (100,000)
400,000
Second trade discount (10% X 400,000) (40,000)
Invoice price 360,000
Cash discount (5% X 360,000) (18,000)
Payment within the discount period 342,000
The journal entry to record the purchase is:

Purchases 360,000
Accounts payable 360,000

Note that the trade discounts are not recorded. The journal entry to record the payment of
the invoice within the discount period is:

Accounts payable 360,000

Cash 342,000
Purchase discounts 18,000
Methods of recording purchases

1. Gross method – purchases and accounts payable are recorded at gross

2. Net method – purchases and accounts payable are recorded at net

Gross method

Purchases on account, P200,000, 2/10, n/30.

Purchases 200,000
Accounts payable 200,000
Assume payment is made within the discount period.

Accounts payable 200,000

Cash 196,000
Purchase discount 4,000

Assume payment is made beyond the discount period

Accounts payable 200,000

Cash 200,000
Net method

Purchases on account, P200,000, 2/10, n/30.

Purchases 196,000
Accounts payable 196,000

Assume payment is made within the discount period.

Accounts payable 196,000

Cash 196,000
Assume payment is made beyond the discount period

Accounts payable 196,000

Purchase discount lost (other expense) 4,000
Cash 200,000

Assume it is the end of accounting period, no payment is made and the discount
period has expired.

Purchase discount lost 4,000

Accounts payable 4,000
Cost of inventories
The cost of inventories shall comprise:

a. Cost of purchase
 Comprises the purchase price, import duties and irrevocable taxes, freight,
handling and other cost directly attributable to the acquisition of finished goods,
materials and services.

 Trade discounts, rebates and other similar items are deducted in determining the
cost of purchase

 The cost of purchase shall not include foreign exchange differences which arise
directly from the recent acquisition of inventories involving a foreign currency.
b. Cost of conversion
 Includes cost directly related to the units of production such as direct labor.
 It also includes a systematic allocation of fixed and variable production overhead
that is incurred in converting materials into finished goods.

 Fixed production overhead is the indirect cost of production that remains relatively
constant regardless of the volume of production.
 Examples are depreciation and maintenance of factory building and equipment,
and the cost of factory management and administration.
 Variable production overhead is the indirect cost of production that varies directly
with the volume of production.
 Examples are indirect labor and indirect materials.
Allocation of fixed production overhead

 The allocation of fixed production overhead to the cost of conversion is based on

the normal capacity of the production facilities.

 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.

 The amount of fixed overhead allocated to each unit of production is not

increased as consequence of low production or idle plant.

 Unallocated fixed overhead is recognized as expense in the period in which it is

incurred.
Allocation of variable production overhead

 Variable production overhead is allocated to each unit of production on the basis

of the actual use of the production facilities.
 A production process may result in more than one product being produced
simultaneously. This is the case, for example, when joint products are produced or
where there is a main product and by-product.
 When the costs of conversion are not separately identifiable, they are allocated
between the products on a rational and consistent basis, for example, on the basis
of the relative sales value of each product.
 Most by-products by their nature are not material.
 By-products are measured at net realizable value and this value is deducted from
the cost of the main product.
c. Other cost incurred in bringing the inventories to their present location
and condition

 Included in the cost of inventories only to the extent that it is incurred

in bringing the inventories to their present location and condition.

 For example, it may be appropriate to include the cost of designing

product for specific customers in the cost of inventories.
However, the following costs are excluded from the cost of inventories and
recognized as expenses in the period when incurred:

a. Abnormal amounts of wasted materials, labor and other production costs.

b. Storage costs, unless these costs are necessary in the production process
prior to a further production stage. Thus, storage costs on goods in process are
capitalized but storage costs on finished goods are expensed.
c. Administrative overheads that do not contribute to bringing inventories to
their present location and condition.
d. Distribution or selling costs
Cost of inventories of a service provider

 The cost of inventories of a service provider consists primarily of the labor

and other costs 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.

 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
incurred.
Thank you
for listening