Ocampo 1-2 | Intermediate Accounting Vol. I 2022 Edition by I i ee, CHAPTER 1 NT: ELEMENTS OF FINANCIAL STATEMENTS _ 5.” - Socrates “The beginning of wisdom is the definition of term: INTRODUCTION This chapter provides a review of the definition and recognition of the elements of financial statements discussed in Concentya ‘on work and Accounting Standards textbooks. It also disct oe the Classification of assets and liabilities depending on how they are presented, recognized and measured. Elements of financial statements are the grouping, into ‘broad classes, of the financial effects of transactions and other events according to economic characteristics. ' The elements directly related to the measurement of financial position are assets, liabilities and equity. These elements are presented in the Statement of Financial Position. The elements directly related to the measurement of financial performance are income and expenses. These elements are presented in the Statement of Financial Performance (PAS 1 currently uses the title Statement of Profit or Loss and Other Comprehensive Income). DEFINITION OF THE ELEMENTS OF FINANCIAL STATEMENTS The Conceptual Framework for Financial Reporting (2018) defines the elements of financial statements as follows: Asset An asset is a present economic resource controlled by the entity as@ result of past events. An economic resource is a right that has’ the Potential to produce economic benefits.Elements of Financial Statements _| 1-3 Chapter The two-part definition of asset clarifies that an asset is the economic resource, not the ultimate inflow of economic benefits. Also, the economic resource is the present right that contains the potential to produce future economic benefits, not the future economic benefits that the right may produce. The three aspects of those definitions include an existing right, potential to produce economic benefits and control. Rights to receive cash, goods or services and rights to use a physical ‘object or intellectual property are common examples of rights that have the potential to produce economic benefits. For that potential to exist, it does not need to be certain, or even likely, that economic benefits will arise. However, a low probability of economic benefits might affect recognition decisions and the measurement of the asset. ‘An economic resource could produce economic benefits for an entity by entitling or enabling it to do, for example,, one or more of the following: receive contractual cash flows or another economic resource; exchange economic resources: with another party on favorable terms; ; «produce cash inflows or avoid cash outflows; i feceive cash or'other economic resources by selling the economic resource; or extinguish liabilities by transferring the economic resource. Control helps to identify the economic resource for which the entity ‘ounts. Control over an economic resource is the present ability to direct its use and obtain the economic benefits that may flow from it. Control also includes the present ability to prevent other parties from doing the same. Therefore, only one party can control an economic resource. acct The following are not considered assets of the entity holding them: 1, Rights of access to public goods, such as public rights of way over land, or know-how that is in the public domain. Debt instruments or equity instruments issued by the entity and repurchased and held by it. Economic resource under the custody of an agent controlled by the principal. 2. &1-4 | Intermediate Accounting Vol. I 2022 Edition by R. R. Ocampo Why? 1. Not all of an entity’s rights are assets of that entity. To. be considered assets of the entity, the rights must both have the Potential to produce for the entity economic benefits beyond the economic benefits available to all other parties and be controlled by the entity. Rights available to all parties without significant cost are typically not assets for the entities that hold them. 2. An entity cannot have a right to obtain economic benefits from itself. 3. The economic resource is an asset of the principal not the agent. Liability A liability is a present obligation of the entity to transfer an economic resource as a result of past events. The separate definition of an economic resource (as part of the definition of an asset) clarifies that a liability is the obligation to transfer the economic resource, not the ultimate outflow of economic benefits. A liability exists if all the following three criteria are satisfied: (a) the entity has an obligation; (b) the obligation is to transfer an economic resource; and (c) the obligation is a present obligation that exists as a result of past events. An obligation is a duty or responsibility that an entity has no practical ability to avoid. An obligation can be ‘legal’ or ‘constructive’. ‘Legal’ obligations are established by contract, legislation or similar means and are legally enforceable by the party to whom they are owed. ‘Constructive’ obligations arise if the entity has no practical ability to act in a manner inconsistent with an entity’s customary practices, published policies or specific statements. Obligations to pay cash and deliver goods or services are common examples of obligations to transfer an economic resource. For a liability to exist, it does not need to be certain, or even likely, that a transfer of economic resource will arise. However, a low probability of transfer of economic resource might affect recognition decisions and the measurement of the liability.ments of Financlal Statements | 1.5 Chapter L If an entity plans to settle an obligation to transfer an economic resource by negotiating a release from It, transferring It to a third party, or replacing it with another obligation by entering Into a new transaction, the entity has the obligation to transfer an economic resource until the entity has settled, transferred or raplaced that obligation, In other words, a liability exists even If the obligation Is not eventually settled by transferring economic resource to another party, A present obligation exists as a result of past events only if the entity has already obtained economic benefits or taken an action and as a consequence, the entity will or may have to transfer an economic resource that It would not otherwise have had to transfer, The following are not considered liabilities of an entity: 1, Cost to overhaul a machine. 2. An entity has entered into a contract to pay an employee a salary in exchange for receiving the employee's services. 3. Share dividends declared but not yet pald. Why? 1, Avoidable -'this is not a present obligation since the entity can avoid it by acquiring a new machine. 2. Executory - the entity does not have a present obligation to pay the salary until it has received the employee's services. 3. Equity - there is no present obligation to transfer an economic resource. Equity Equity ‘is the residual interest in the assets of the entity after deducting all its liabilities. In equation form, Assets - Liabilities = Equity. The definition of equity reminds us of the basic accounting equation, Assets = Liabilities + Equity. Equity claims are claims against the entity that do not meet the definition of a liability.1-6 | Intermediate Accounting Vol. I 2022 Edition by R. R. Ocampo Income Income is increases in assets, or decreases in liabilities, that result in increases in equity, other than those relating to contributions from holders of equity claims. A Simply stated, income is increase in equity other than contributions from holders of equity claims. For example, asset received by way of donation is not income if given by an owner but can be considered as income if given by a non-owner. The definition of income encompasses both revenue and gains, Revenue arises in the course of the ordinary activities of an entity. Gains represent other items that meet the definition of income and may, or may not, arise in the course of the ordinary activities of an entity. Expenses Expenses are decreases in assets, or increases in liabilities, that result in decreases in equity, other than those relating to distributions to holders of equity claims. Simply stated, expenses are decreases in equity other than distributions to holders of equity claims. For example, dividends paid to owners of preference shares issued by an entity are not expenses unless the preference shares are, in substance, financial liabilities. The definition of expenses encompasses losses as well as those expenses that arise in the course of the ordinary activities of the entity. Losses represent other items that meet the definition of expenses and may, or may not, arise in the course of the ordinary activities of the entity. Comprehensive income Income and expenses, are basically changes in equity from non-owner transactions. Income minus expenses recognized during the period is known as comprehensive income. It comprises all components of ‘profit or loss’ and of ‘other comprehensive income’.Chapter 1 - Elements of Financial Statements _|_1-7 All income and expenses not required or allowed to be recognized in other comprehensive income are recognized in profit or loss. Typical items of other comprehensive income include changes in revaluation surplus, gains and losses on financial assets at fair value through other comprehensive income and remeasurements of defined benefit plans. Although income and expenses are defined in terms of changes in assets and liabilities, information about income and expenses is just as important as information about assets and liabilities. RECOGNITION OF THE ELEMENTS OF FINANCIAL STATEMENTS. Recognition is the process of capturing for inclusion in the statement of financial position or the statement(s) of financial performance an item that meets the definition of an asset, a liability, equity, income or expenses. The amount at which’ an asset, a liability or equity is recognized in the statement of financial position is referred to as its carrying amount. Recognition links the elements, the statement of financial position and the statement(s) of financial performance. This linkage is beautifully illustrated in the Conceptual Framework for Financial Reporting (2018) as follows: jement of financial position at beginning of reporting period Assets minus liabilities equal equity + ‘Statement(s) of financial performance, Income minus expenses + ‘Changes in equity Contributions from holders of equity claims minus distributions to holders of equity claims ‘Siatement of financial position at end of reporting period _ Assets minus liabilities equal equityR. Ocampo | Intermediate Accounting Vol. I 2022 Edition by R Recognition criteria Recognition of an item that meets the definition Of neath reat i; is iate if I financial statements is appropria income and expenses ang information about assets, liabilities, equity, eae a faithful representation of those items, because the aim is to’ providg information that is useful to investors, lenders and other creditors, iti i in relevant information may be Whether recognition of an item results in reley 0 n affected by ‘ow probability of a flow of economic benefits and existence uncertainty. Whether recognition of an item results in a faithful representation may be affected by measurement uncertainty, recognition inconsistency (accounting mismatch), and presentation and disclosure. Not all items that meet the definition of one of the elements of financial statements are recognized. Recognition is not appropriate if it will not result in relevant information and faithful representation of the elements. Cost constrains recognition decisions, just as it constrains other financial reporting decisions Take note! In The Conceptual Framework for Financial Reporting (2010), the recognition criteria were that an entity should recognize an item that met the definition of an element if it was probable’ that economic benefits would flow to the entity and if the item had a cost or value that could be determined reliably. The revised recognition criteria refer explicitly to the qualitative characteristics of useful information. The International Accounting Standards Board’s aim was to develop a more coherent set of concepts, not to increase or decrease the range of assets and liabilities recognized. Since the Conceptual Framework for Financial Reporting (2018) is relatively new, don’t be, confused if you will see the previous recognition criteria in the existing PFRSs. owChapter 1 - Elements of Financial Statements _|_1-9 CLASSIFICATION OF ASSETS AND LIABILITIES Current/Non-current (For presentation purposes) PAS 1 requires an entity to present current and non-current assets, and current and non-current liabilities, as separate classifications in its statement of financial position. An entity shall classify an asset as current when: (a) it expects to realize the asset, or intends to sell or consume it, in its normal operating cycle; (b) it holds the asset primarily for the purpose of trading; (c) it expects to realize the asset within twelve months after the reporting period; or (d): the asset is cash or cash equivalent unless the asset is restricted from being exchanged or used to settle a liability for at least twelve months after the reporting period. An entity shall classify all other assets as non-current. Examples of current assets corresponding to the characteristics noted above: (a) Trade receivables, inventories and prepayments (b) Held for trading financial assets (c) Other receivables expected to be collected within 12 months after the reporting period (d) Unrestricted cash and cash equivalents Examples of non-current assets include property, plant and equipment, investment property, intangible assets, and investment in associate. ' An entity shall classify a liability as current when: (a) it expects to settle the liability in its normal operating cycle; (b) it holds the liability, primarily for the purpose of trading; (c)_ the liability is due to be settled within twelve months after the reporting period; or (d)_ it does not have an unconditional right to defer settlement of the liability for at least twelve months after the reporting period. Terms of a liability that could, at the option of the counterparty, result in its settlement by the issue of equity instruments do not affect its classification. An entity shall classify all other liabilities as non-current.1-10 | Intermediate Accounting Vol. I 2022 Edition by R. R. Ocampo Examples of current liabilities corresponding to the characteristics noted above: (a) Trade payables and accruals (b) Held for trading financial liabilities (c) Current portion of long-term debt (d) Notes payable on demand Examples of non-current liabilities include long-term debt (mortgage, notes and bonds payable) and deferred tax liability. Financial/Non-financial (For recognition and measurement purposes) In accordance with PAS 32, a financial instrument is any contract that gives rise to a financial asset of one entity and a financial liability ‘or equity instrument of another entity. A financial asset is any asset that is: I. Cash; Il. An equity instrument of another entity; III. A contractual right to receive cash or another financial asset from another entity; IV. A contractual right to exchange financial assets or financial liabilities with another entity under conditions that are potentially favorable to the entity; Vv. Accontract that will or may be settled in the entity's own equity instruments and is a non-derivative for which the entity is or may bé obliged to receive a variable number of the entity's own equity instruments; or VI. A contract that will or may be settled in the entity's own equity instruments and is a derivative that will or may be settled other than by the exchange of a fixed amount of cash or another financial asset for a fixed number of the entity's own equity instruments. Examples of financial assets corresponding to the definition noted above: < I. Cash on hand and in banks IL. Investments in equity instruments (such as ordinary shares) Ill. Receivables and investments in debt instruments (such as bonds) IV. Derivative assetsChapter 1 - Elements of Financial Statements | 1-11 V. A contract to receive as many the entity's own ordinary shares as will equal P1,000,000 VI. A favorable forward to sell an entity’s own ordinary shares that can be settled net in cash Items V and VI remind: us that not all contracts that will or may be settled in the entity's own equity instruments are equity instruments. We'll discuss these items in Volume II. Volume I covers items I to IV. A financial liability is any liability that is: I. A contractual obligation to deliver cash or another financial asset to another entity; II. A contractual obligation to exchange financial assets or financial liabilities with another entity under conditions that are potentially unfavorable to the entity; III. A contract that will or may be settled in the entity's own equity instruments and is a non-derivative for which the entity is or may be obliged to deliver a variable number of the entity's own equity instruments; or IV. .A contract that will or may be settled in the entity's own equity instruments and is a derivative that will or may be settled other than by the exchange of a fixed amount of cash or another financial asset for a fixed number of the entity's own equity instruments. Examples of financial liabilities corresponding to the definition noted above: . I Accounts, notes and bonds payable Il. Derivative liabilities III. A contract to deliver as many the entity's own ordinary shares as will equal P1,000,000 IV. An unfavorable forward to sell an entity's own ordinary shares that can be settled net in cash Items III and IV are similar to items V and VI for financial assets ‘but with a different perspective and condition. We'll discuss financial liabilities in Volume II. ‘As mentioned in the Preface, we'll discuss non-financial assets first before financial assets and then financial liabilities followed by non- financial liabilities. This sequence provides continuity of discussion on financial instruments.Chapter 2 - Inventories_|_2-1 CHAPTER 2 INVENTORIES LEARNING OBJECTIVES: After studying this chapter, you should be able to: 1. Identify the authoritative pronouncements on accounting for inventories. f 2. Define inventories. 3. Explain why an item is included or not included in inventories. 4. Identify. the transactions affecting inventories and their effect on the carrying amount of inventories. 5. Describe periodic and perpetual inventory systems. 6. Identify the items included in cost of inventories. 7. Solve inventory measurement problems: 8. Explain recognition of inventories as expense. 9, Illustrate the different cost formulas. 10. Explain net realizable value (NRV). 11. Illustrate determination of NRV. 12. Explain write-down to NRV and reversal. 13. Explain accounting for discounts. 14. Explain, accounting for purchase commitments. Describe the presentation and disclosure requirements for inventories. 15.tion by R. R. Ocampo 2-2 | Intermediate Accounting Vol. 12022 Edi CHAPTER 2 INVENTORIES awesome. People buy hat you do iS whe — Tara Gentile “Pe fon’t buy because copie don te feel awesome. because it makes them INTRODUCTION recognition, _Measurement, h the nature, in accordance with leals_ wit inventories This chapter di id disclosures of presentation an following: PAS 2 - Inventories; and PIC Q&A 2018-10 - Scope of disclosure of inventory write-downs. ventories are also discussed. Techniques used Other issues related to im included in the next chapter. to estimate inventories art NATURE OF INVENTORIES PAS 2 defines inventories as 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. To be considered as inventory, it is not enough that the asset is ‘held for sale’, The sale must be in the ordinary course of business. Therefore, a car held for sale is inventory of a car manufacturer (¢.9. Toyota Motor Corporation) but not of a CPA review center (e.g. Team PRTC CPA Review). Materials and supplies are inventories if they are to be consumed in the production process or in the renderin i prc ig of services. Therefore, office and advertising supplies would not qualify as inventories The composition of inventories de, pends on the nature of the ity. Items (a), (b) and (c) of the definition apply to manufacturing se iesChapter 2 - Inventories_| 2-3 Only item (a) applies to trading or merchandising entities. For service entities, only item (c). Items Included in Inventories Based on the definition, the following can be considered as inventories: * Merchandise purchased by a retailer and held for resale 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 Inventories are assets. Therefore, to be included in inventories the entity must have control over them. As discussed in Chapter 1, control is the ability to direct the use of and obtain substantially all of the remaining economic benefits from the assets and the ability to prevent others from doing the same. Control of an asset usually atises from an ability to enforce legal rights. Therefore, in most cases, ‘owned include, not owned exclude’. The following discussion provides guidance in’ determining who is the owner of the goods and as such, shall include them in its inventory. Goods in Transit Terms of shipment determine the owner. Free On Board (FOB) shipping point - Owned by the buyer since title of ownership transfers upon the goods leaving the seller's location. This is also known as FOB origin or FOB seller. FOB destination - Owned by the seller since title of ownership transfers when the goods reach the buyer's location. This is also known as FOB buyer. Goods ‘on Consignment Owned by the consignor (principal) since it has control over the goods and not the consignee (agent). Therefore, the goods are included in inventory if the entity is the consignor (out on consignment) and excluded if the entity is the consignee (held on consignment).2-4 | Intermediate Accounting Vol. I 2022 Edition by R. R. Ocampo Goods Used as Collateral Owned by the borrower not the lender. The carrying amount of goog, used as collateral should be disclosed. Goods Sold The goods are excluded from the seller’s inventory if the transaction qualifies for recognition as revenue. In accordance with PFRS 45, revenue is recognized as control over the goods is passed. This normally happens at the point of sale (ie., when the goods are delivered). Revenue recognition from sale of goods becomes complicated when there is a repurchase agreement, right of return, bill-and-holg arrangement or the seller retains legal title until the buyer is fully paid, These and other revenue recognition complexities are outside of the scope of Intermediate Accounting and are thoroughly discussed in Advanced Accounting (Special Transactions) textbooks. But as a simple guide, the ‘goods related to these transactions are excluded from the seller's inventory if control over the goods is passed to the buyer. TRANSACTIONS AFFECTING INVENTORIES Typical transactions related to inventories and their effect include: e 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 Accounting for consignment sales is another topic in Advanced Accounting. The effect of consignment transactions is included only for emphasis. In relation to purchases and’sales, accounting depends 0" the system used by the entity (i.e., periodic or perpetual). JChapter 2 - Inventories _| 2-5 Periodic and Perpetual Inventory System Periodic and perpetual inventory systems are methods used to keep track of the goods on hand and sold. The main difference between the two systems is the availability of information. In periodic system, the information is available at the end of each period after the entity has conducted physical count of the goods. In perpetual system, the information is readily available from the ‘perpetual records’, which is automatically updated for transactions affecting inventories. The following table summarizes the other differences between the two systems: Perpetual Record keeping ~ | Can be manual Usually computerized Entities using the ‘Small businesses with low | Most trading entities system sales volume | Differences Periodi Recording of Debit: Purchases Inventory purchases on Credit: Accounts payable \ccounts payable account* Recording of Debit: Accounts payable | Debit: Accounts payable purchase returns Credit: Purchase returns Credit: Inventory (received credit memo from supplier)** Recording of cost of | None Debit: Cost of sales sales Credit: Inventory (Every time a sales transaction is made) Cost of sales Inventory, beg. Px | Available from the records | computation Purchases, net ioe | TGAS*** Xx g Inventory, end. Cost of sales | Recording of cost of | None Debit: Inventory sales returns in Credit: Cost of sales good condition**** i ee Physical count Done to determine goods | Done to check accuracy of on hand perpetual records * For cash purchases, credit Cash ** — For cash refund, debit Cash *** Total goods available for sale 461 For goods returned which are unsalable, no entry in both systemsOcampo | Intermediate Accounting Vol. 1 2022 Edition by R. P RECOGNITION Recognition of inventories is not specified in pas 2. Therefore, an nition criteria for the elements of 1. Recognition of entity applies the general recog! financial statements discussed in Chapter n if it results in relevant and faithful inventories is appropriate representation of the information about inventories. MEASUREMENT ies are required to be measured at In accordance with PAS 2, inventori le value (NRV)- the lower of cost and net realizabl This measurement principle does not apply to: ; (a) producers of agricultural and forest products, agricultural produce efter harvest, and minerals and mineral products, to the extent that they are measured at NRV in accordance with well- established practices in those industries; and ; (b). commodity broker-traders who measure their inventories at fair value less costs to sell. Broker-traders are those who buy or sell commodities for others or on their own account. Changes in NRV or fair value less costs to sell are recognized in profit or loss in the period of change. Items Included in Cost The cost of inventories comprises all costs of purchase, costs of conversion and other costs incurred in bringing the inventories to their present location and condition. Costs of Purchase The costs of purchase of inventories comprise: (a) the purchase price; (b) import duties and non-refundable purchase taxes; c es; and (c) transport, handling and other costs directly attributable to the acquisition of finished goods, materials and services Trade discounts, rebates and other similar i determining the costs of purchase. ilar items are deducted i0 > |Chapter 2 ~ Inventories | 2-7 Costs of Conversion , Costs of conversion are costs incurred to convert materials into finished goods. These include costs directly related to the units of production (direct labor) and systematic allocation of fixed and variable production overheads. Examples of production (factory) overhead include: (a) depreciation and maintenance of factory buildings, equipment and right-of-use assets used in the production process; (b) cost of factory management and administration; (c) indirect materials; and (d) indirect labor. Items (a) and (b) are examples of fixed production overheads, which are indirect costs of production that remain relatively constant regardless of the volume of production. Items (c) and (d) are examples of variable production overheads, which are indirect costs of production that vary directly, or nearly directly, with the volume of production. Fixed production overheads are allocated to the costs of conversion based on the normal capacity of the production facilities. Variable production overheads are allocated to each unit of production on the basis of the actual use 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 actual level of, production may be used if it approximates normal capacity. 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. For example, it may be appropriate to include non-production overheads or the costs of designing products for specific customers in the cost of inventories. Accounting for materials, direct labor and factory overhead is thoroughly discussed in Cost Accounting textbooks. Joint and by- products are also discussed in Cost Accounting.2-8 |_Intermediate Accounting Vol. I 2022 Edition by R_R. Ocampo. Items Not Included in Cost Examples of costs excluded from the cost of inventories ang recognized as expenses in the period in which they are incurred: * Unallocated overheads . * Abnormal amounts of wasted materials, labor or other production costs Storage costs, unless those costs are necessary In the production process before a further production stage : | Administrative overheads that do not contribute to bringing inventories to their present location and condition * Selling costs Foreign exchange differences arising directly on the recent acquisition of inventories invoiced in a foreign currency For inventories purchased with deferred settlement terms, the difference between the purchase price for normal credit terms and the amount paid is recognized as interest expense over the period of financing. RECOGNITION AS EXPENSE The following are recognized as expense in the period in which they occur: * The carrying amount of inventories when inventories are sold * The amount of any write-down of inventories to NRV « All losses of inventories Inventories allocated to other asset accounts, for example, inventory. used as a component of, self-constructed property, plant and equipment are recognized as an expense during the useful life of that asset. COST FORMULAS A primary issue in accounting for inventories is the amount of cost to be recognized as an asset and carried forward until the related revenues are recognized.Chapter 2 - Inventories | 2-9 To emphasize this issue, assume an entity has 100 units on hand at the beginning of the accounting period. The entity purchased 700 units and sold 600 units. So, the entity has 200 units at the end of the accounting period. The accounting questions now are: 1. How much is the cost of the 200 units on hand (asset)? 2. How much is the cost of the 600 units sold (expense)? The answers will depend on the cost formula used by the entity - specific identification, first-in, first-out (FIFO)'or weighted average. Specific Identification Specific identification of cost means that specific costs are attributed to identified inventory. FIFO The FIFO formula assumes that the items of inventory that were purchased or produced first are sold first, and consequently the items remaining in inventory at the end of the period are those most recently purchased or produced. Stated differently, last-in, last-out. Weighted Average Under the weighted average cost formula, 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. The average may be calculated on a periodic basis, or as each additional shipment is received, depending upon the circumstances of the entity. Computation of the cost of ending inventory Specific identification: Units on hand x Specific unit cost FIFO Units on hand x Unit cost of latest purchases2-10 | Intermediate Accounting Vol. 12022 Edition by R. R. Ocampo Weighted Average Units on hand x Weighted Average Unit Cost (WAUC) WAUC = Total cost of goods available for sale Total units available for sale Illustration 1.1 - Cost formulas actions for the month of June; Assume an entity has the following trans Purchases Units Unit cost Total cost June 1 (balance) 400 —~P3.20 P 1,280 3 1,100 3.10 3,410 7 600 3.30 1,980 15 900 3.40 3,060 22 250 3.50 875 3,250 P10,605 Sales Units Selling price per unit June 2 300 P5.50 6 800 5.50 10 700 6.00 18 700 6.00 25 150 6.00 On hand as of June 30, 600 units. Required: Determine the cost of inventory as of June 30 and cost of sales for the month of June using: 1, Specific identification, assuming the 600 units came from June 3 purchases FIFO, periodic FIFO, perpetual Weighted average, periodic Weighted average, perpetual (Moving average) yPwrChapter 2 ~ Inventories _| Solution to Requirement No. 1 - Specific identification Cost of June 30 inventory (600 units x P3.10) P1,860 Cost of sales: Total goods available for sale ‘ P10,605 Less inventory, June 30 —1,860 Solution to Requirement No. 2 - FIFO, periodic Cost of June 30 inventory: | From June 22 (250 units x P3.50) P 875 | From June 15 (350 units x P3.40) 1,190 | 2,065 Cost of sales: | Total goods available for sale P10,605 } Less inventory, June 30 2,065 | P8540 | Solution to Requirement No. 3 - FIFO, perpetual | Purchases Sales ~ Balance } Unis Unitcost Totaleost | Units Unitcost Totalcost | Units Unitcost Total cost June 1 400 4,280 une 2 300-520 360| 1003.20 320 tunes} 100-340 3,410 1003.20 320 11003103410 Tune 6 100-320 320 310___2170| 400320 4,240 Tune7} 600 ——«330~—~—« 980 4003.10 ——,240 600330 1,980 Tune 10 00 «340 —~,240 300__330 990 | 3003.30 990 Tone is] 900340 —~3,060 3003.30 990 9003.40 3,060 Tune 18] 300330 350 #oo___340___1360| 500+ 3.40 1,700 Tone 22} 2503.50 cd 500-340 _4,700 250350875 June 25 150 «340 sio] 350340 1,190 250350, 875, Total 2850 37325 | 2,680, asia] 600 2,065, Cost of June 30 inventory (from the records) P2,065 Cost of sales (from the records) P8,5402-12 | Intermediate Accounting Vol. I 2022 Edition by RR. Ocampo Notice that the cost of June 30 inventory and cost of sales are the same under periodic and perpetual FIFO. Solution to Requirement No. 4 - Weighted average, periodic Weighted average unit cost: Total goods available for sale P10,605 Divide by total units available for sale — 3,250 Cost of June 30 inventory (600 units x P3.26) P1956, Cost of sales: Total goods available for sale P10,605 Less inventory, June 30 —1,956 P_.8,649 Solution to Requirement No. 5 - Moving average Purchases Sales Balanee Uh Uniteost Totaleost| Units Unltcost Totalcost| Units Unitcost Tetaast sune 1 400320 “2 une 300520560] 1003.20 0 June 3|__ 1,100 3.10 3,410 1,200. 51° 3,730 “une 6] ios as [40032 1202 June 7) 600 3.30 1,980. 1,000. 3.22 * 3,222 Tune 1 Fo aA 3008 368 June 15| 900 3.40 3,060 1,200 _ 3.36 * 4,028 une 1 70336 5382 | $003.36 1.676 June 22| 250 3.50, 875. 750 3.40 © 2,551, Tune 25 je 3a0 SO | 6003.40 2,04 “tall 2,850 330s | 7650 356 + 73,730/%,200 °° p3,222/1,000 * p4,028/1,200 * p2,551/750 Cost of June 30 inventory (from the records) 2,041 Cost of sales (from the records) P8,564 or Cost of sales: ne goods available for sale P10,605 ss inventory, June 30 2,041 P_8,564Chapter 2 - Inventories | 2-13 Notice the difference in the cost of June 30 inventory and cost of sales under periodic and perpetual average. This is due to the timing of computing the weighted average unit cost. This is computed only at the end of period under periodic while this is updated every purchase under perpetual. Selection of Cost Formula Specific identification is required for items that are not ordinarily interchangeable and for goods or services produced and segregated for specific projects. If specific identification is not required, an entity shall use either FIFO or weighted average. The choice is a matter of accounting policy so the method selected should be used consistently. Anas in method is accounted for retrospectively in accordance with P, . An entity shall use the same cost formula for all inventories having a similar nature and use to the entity. For inventories with a different nature or use, different cost formulas may be justified. NET REALIZABLE VALUE (NRV) As noted earlier, inventories are required to be measured at the lower of cost and NRV. 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. NRV refers to the net amount that’an entity expects to realize from the sale of inventory in the ordinary course of business. NRV is entity- specific value. Therefore, NRV for inventories may not equal fair value less costs to sell since fair value is a market-based measurement. Guidance in determining NRV Estimates of NRV are based on the most reliable evidence available at the time the estimates are made, of the amount the inventories are expected to realize.2-14 | Intermediate Accounting Vol. I 2022 Edition by R. R- Ocampo These estimates take into consideration: (a) fluctuations of price or cost directly relating to events OCCurr, after the end of the period to the extent that such events Confing conditions existing at the end of the period; and (b) the purpose for which the inventory: is held Inventory held to satisfy firm sales or service contracts The issue is what selling price to use? The NRV is based on the contract price. If the sales contracts are fo, less than the inventory quantities held, the NRV of the excess is baseq on general selling prices. To illustrate, assume the following information related to inventories held by an entity at the end of the reporting period: Per unit General selling price P82 Selling price in a binding contract to sell 84 Quoted price in an active market for similar asset 81 Estimated costs to sell 10 The NRV per unit of the inventories is computed as follows: Units under contract to sell Selling price in a binding contract to sell P84 Estimated costs to sell 10) P72: Units not under contract to sell General selling price P82 Estimated costs to sell 10 P72 The quoted price in an active market for similar asset is not considered since NRV is entity-specific value not a market-based measurement.—e Chapter 2 - Inventories _| 2-15 Materials and other supplies held for use in the production 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. However, when a decline in the price of materials indicates. that the cost: of the finished products exceeds NRV, the materials are written down to NRV. In such circumstances, the replacement cost of the materials may be the best available measure of their NRV. To illustrate, assume the following information related to raw materials inventory held by an entity. at the end of the reporting period: Item X Item Y Cost P200,000 P400,000 Replacement cost 180,000 370,000 Estimated costs to convert materials into finished goods. 100,000 200,000 Estimated selling price of finished.goods 320,000 610,000 Estimated costs to sell 10,000 15,000 Question: Should the entity write-down the raw materials inventory to NRV? Item X Cost of materials P200,000 Estimated costs to convert materials into finished goods 100,000 Estimated total cost of finished goods P300,000 NRV of finished goods (P320,000 - P10,000) 310,000 Answer: No, since the entity expects to sell the finished products in which item X will be incorporated above cost. This is despite the fact that the NRV (replacement cost) of item X is below cost.n by R. Re Ocampo P400,000 Cost of materials Estimated costs ert materials into costs to conv 200,000 200,000 finished goods 600,000 Estimated total cost of finished goods NRV of finished goods (P610,000 - P15,000) £595,000 Answer: Yes, since the entity expects to sell the finished products in which item Y will be incorporated below NRV. In this case, the entity will write-down item Y to P370,000. The NRV of finished goods is used only to determine whether the materials should be written down below cast. But in computing the amount of write- down, the entity will use the replacement cost of materials not the NRV of finished goods. Write-down to Net Realizable Value The cost of inventories may not be recoverable if: (a) those inventories are damaged; (b) those inventories have become wholly or partially obsolete; (c) their selling prices have declined; or (d) the estimated costs of completion or the estimated costs to be incurred to make the sale have increased. The practice of writing inventories down below cost to NRV is consistent with the view that assets should not be carried in excess of amounts recoverable from their sale or use. The excess of cost over the amount recoverable is no longer an asset and should be recognized as expense (loss on write-down). Inventories are usually written down to net realizable value item by item. However, items of inventory relating to the same product line that have similar purposes or end uses, are produced and marketed in the same geographical area, and cannot be practicably evaluated separately from other items in that product line, may be grouped.— Chapter 2 - Inventories | ‘2-17 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 operating segment. To illustrate, assume the following information related to inventories held by an entity at the end of the reporting period: Item Cost NRV P P 100,000 P 80,000 R 200,000 210,000 iT, 300,000 270,000 c 400,000 425,000 Total Pi.000,000 985,000 The amount to be recognized as inventories in the statement of financial position in accordance with PAS 2 and the loss on write-down are computed as follows: Iter 3 Lower of Cost and NRV Loss* “"“P g0,000 20,000 200,000 4 270,000 30,000 —400,000 Total P950,000 * Cost minus lower of cost and NRV a47 The loss on write-down can be computed also as follows: Total cost 1,000,000 Inventory at the lower of cost and NRV 950,000) Required allowance for write-down to NRV 50,000 Recorded allowance for write-down to NRV - Increase (decrease) in allowance P__50,000 The amount of any write-down of inventories to NRV shall be recognized as an expense in the period the write-down occurs. Journal entry to recognize the write-down (Allowance method): Loss on write-down to NRV P50,000 Allowance for write-down to NRV P50,0002-18 | Intermediate Accounting Vol. 1 2022 Edition by R_R_ Ocampo The loss on write-down to NRV is usually presented as an addition 4 e-down is not recorde, cost of sales. Alternatively, the ‘loss on write | separately but simply included in total costs of sales (Direct method), The cost of sales under the two methods is computed as follows: Allowance Direct Te i I otal goods available for sale 8,000,000 8,000,000 (assumed figure) Inventory, end. (1,000,000)* 50,000)** Cost of sales 7,000,000 7,050,000 Loss on write-down to NRV 50,000 = Total cost of sales P7,050,000 2,050,000 * At cost, a separate account for allowance is maintained ** At the lower of cost and NRV Reversal of Write-down to NRV ‘A new assessment is made of NRV at the end of each period. The amount of the write-down is reversed when the circumstances that previously caused inventories to be written down below cost no longer exist or when there is clear evidence of an increase in NRV because of changed economic circumstances. The reversal is limited to the amount of the original write-down so that the new carrying amount is the lower of the cost and the revised NRV. This occurs, for example, when an item of inventory that is carried at NRV, because its selling price has declined, is still on hand in a subsequent period and its selling price has increased. To illustrate, using the same information in the previous illustration 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 Required allowance for write-down to NRV 50,000 Recorded allowance for write-down to NRV 70,000). Increase (decrease) in allowance P(_20,000) Journal entry to recognize the reversal of write-down: Allowance for write-down to NRV P20,000 Reversal of write-down to NRV P20,000The amount of reversal of write-down to NRV shall be recognized as a reduction in the amount of inventories recognized as an expense (cost of sales) in the period in which the reversal occurs. OTHER TOPICS Accounting for Discounts Accounting depends on the type of discount - trade or cash. Trade discount is a deduction from the list price given by the seller to the buyer. This is used by the seller to generate or increase sales. This is not accounted for separately. Purchases are always recorded net of trade discounts. i Cash discount is a deduction from the invoice price given by the seller to the buyer. The seller offers this to encourage the buyer to make prompt payment. This can be accounted for using either gross or net method. Gross and net method of accounting for cash discounts The following table summarizes the differences between the two methods. Gros: Net Cash discounts Deducted from Deducted from purchases/cost of purchases/cost of inventory when taken inventory whether taken or not Cash discounts Deducted from Not accounted for taken purchases/cost of separately since already inventory | deducted from (purchase discounts) purchases Cash discounts | Included in | Reported as other not taken purchases/cost of expense inventory (forfeited purchase | discounts)20 | Intermediate Accounting Vol. I 2022 Edition by R. R. Ocampo Illustration 1.2 - Gross and net method Buyer Corp. regularly buys goods from Vendor Corp. and is alloweg trade discounts of 20% and 10% fiom the list price. Buyer Purchasey goods from Vendor and received an invoice with a list price of P100,000 and payment terms 2/10, n/30. Invoice price (P100,000 x .8 x .9) 72,000 The journal entries using gross and net method under the period, inventory system: Gross : To record the purchase: "i ca Purchases P72,000 Purchases Accounts payable P72,000 | (P72,000 x .98) 70,560 Accounts payable P70,560 To record the payment within the discount period: Accounts payable P72,000 Accounts payable —_P70,560 Cash 70,560 | Cash P70,560 Purchase discounts 1,440 To record the payment beyond the discount period: Accounts payable P72,000 Accounts payable P70,560 Cash P72,000 | Forfeited purchase i discounts 1,440 Cash P72,000 | Adjusting entry at the end of the period if the discount period has already lapsed: None Forfeited purchase discounts P1,440 Accounts payable P1,440Chapter 2 - Inventories | 2-21 ne What method to use? Either is acceptable. It is just a matter of preference. Theoretically, the net method is better since the net amount effectively represents the cash price. And in theory, any amount paid in excess of the cash price should be treated as expense (finance cost). However, because the net method is inconvenient to use (i.e., the entity needs to account separately for the forfeited purchase discounts), the gross method is often used. Purchase Commitments Purchase commitment is a contract to buy goods at a fixed price at a specified future date. An entity normally enters into a purchase commitment to protect itself against price increases. This also exposes the entity to a purchase commitment loss if the contract cannot be cancelled and the prevailing price falls below the contract price. Purchase commitments are executory contracts. As defined in PAS 37, executory contracts are contracts under which’ neither party has performed any of its obligations or both parties have partially performed their obligations to an equal extent. That is why they are not recognized in the financial statements unless the contracts are onerous. Purchase commitments should be disclosed. Onerous purchase commitments An onerous contract is a contract in which the unavoidable costs of meeting the obligations under the contract exceed the economic benefits expected to be received under it. PAS 37 applies to executory contracts when they are onerous. To illustrate, assume that on Dec. 8, 2020, an entity entered into a commitment to buy 20,000 units of a certain raw material for P40 per unit to be delivered on Feb. 14, 2021. The contract cannot be cancelled.2-22 | Intermediate Accounting Vol. I 2022 Edition by R. R. Ocampo The prevailing price per unit of this material follows: Dec, 31, 2020 P35 Feb. 14, 2021 P32 Journal entry on relevant dates using perpetual inventory system: Dec. 8, 2020 None, memorandum entry only Dec. 31, 2020 Purchase commitment loss P100,000* Purchase commitment liability P100,000 * [20,000 units x (P40 - P35)] Feb. 14, 2021 Materials inventory P640,000* Purchase commitment liability 100,000 Purchase commitment loss 2 60,000** Accounts payable P800,000*#* * (20,000 units x P32) ** [20,000 units x (P35 - P32)] *** (20,000 units x P40) Assuming that the prevailing price per unit of this material is P42 on Feb. 14, 2021, the journal entry is: Materials inventory P800,000* Purchase commitment liability 100,000 ‘Accounts payable P800,000 Purchase commitment gain 100,000 * (20,000 units x P40) Notice that the purchase commitment gain is recognized only to ‘the extent of purchase commitment loss previously recognized. This consistent with the measurement of inventories at the lower of co and NRV.Chapter 2 - Inventories_|_2-23 The purchase commitment .loss is other expense while purchase commitment gain is other income in the statement of profit or loss. The purchase commitment liability is included in the line item ‘provisions’, Purchase commitment loss not recognized Loss recognition is not appropriate if the contract can be cancelled, amended as to price, or decline in prevailing price does not suggest reduction in sales price. Purchase commitments that can be settled net in cash PFRS 9 shall be applied to contracts to buy ar sell a non-financial item that can be settled net in cash or another financial instrument, as if the contracts were financial instruments. PRESENTATION AND DISCLOSURES PAS 1 requires inventories to be presented in the statement of finaricial position as a separate line item under current assets. The financial statements shall disclose: (a) the accounting policies adopted in measuring inventories, including the cost-formula used; (b) the total carrying amount of inventories and the carrying amount in classifications appropriate to the entity (merchandise, production supplies, materials, work in progress and finished goods); (c) the carrying amount of inventories carried at fair value less costs to sell (applicable to broker-traders); (d) the amount of inventories recognized as an expense during the eriod; (e) the amount of any write-down of inventories recognized as an expense in the period; (f) the amount of any’ reversal of any write-down that is recognized as a reduction in the amount of inventories recognized as expense in the period; (g) the circumstances or events that led to the reversal of a write- down of inventories in accordance with paragraph 34; and (h) the carrying amount of inventories pledged as security for liabilities.2-24 | Intermediate Accounting Vol. I 2022 Edition by R. R. Ocampo In relation to item (e), is an entity required to disclose a write-down o¢ any inventory at the end of an annual reporting period or any write, down during the annual reporting period? In accordance with PIC Q&A 2018-10 - Scope of disclosure o¢ inventory write-downs, an entity is required to disclose only Write. downs of inventory held at the end of the reporting period. This is because an entity only performs the lower of cost and NRV test at reporting date.Chapter 3 - Estimating Inventories _|_3-1 CHAPTER 3 ESTIMATING INVENTORIES LEARNING OBJECTIVES: After studying this chapter, you should be able to: 1. Identify the situations when estimate is needed to determine cost of inventories. - 2. Identify the techniques used to estimate the cost of inventories. 3. Solve inventory estimation problems using the gross profit rate method. 4. Solve inventory estimation problems using the FIFO retail method. 5. Solve inventory estimation problems using the average retail method. 6. Explain why the conventional retail method is no longer allowed.3 Ocampo by R. 2.1 Intermediate Accounting Vol. 1 2022 Edition bY CHAPTER 3 ESTIMATING INVENTORIES i i ture of.» TO estimate is to determine roughly the size, extent or nature of,” _ Merriam-Webster Dictionary INTRODUCTION The word estimate is derived from the Latin word aestimare, Meaning ‘to value’. Since actual amounts are not always available or sometimes impractical to obtain, estimates are normally used in accounting. One of which is determining the value of inventories. Inventory values are estimated when a physical inventory count is not Practical, inventory is destroyed or to test the validity of inventory cost generated by the entity’s inventory system. Entities normally perform physical iriventory count to get the cost of inventory on hand. However, this may be costly since it could mean Closing the store to get an accurate count. Even if this is done only at the end of the accounting period, this may not be practical if inventory is composed of large numbers of rapidly changing items. And imagine the cost involved if the entity will do this every time it prepares interim financial reports. Estimate may also be needed if the inventories are destroyed because of fire, flood and other man-made or natural disasters. Estimate is necessary to determine the extent of the damage to the inventories. Estimate is also useful in testing the validity determined either under periodic or estimate can uncover inventory shorta: 'y of inventory cost Perpetual system. The use of ge Or overage, TECHNIQUES USED TO ESTIMATE COST OF INVENTORIES Techniques for the measurement of the co: used for convenience if the results approxim: to estimate cost of inventories include: st of inventories may be late Cost. Techniques usedChapter 3 - Estimating Inventories | _3-3 * Gross profit method « Retail inventory method « Standard cost method Although commonly used to estirnate the cost of inventories, the gross profit method is not normally acceptable for year-end financial reporting purposes. PAS 2, allows the use of retail inventory and standard cost method. Standard costs take into account normal levels of materials and supplies, labor, efficiency and capacity utilization. They are regularly reviewed and, if necessary, revised in the light of current conditions. Standard costing is extensively discussed in Cost Accounting Textbooks. The gross profit and retail inventory method are discussed in this chapter. GROSS PROFIT METHOD The gross profit method assumes that the gross profit rate (also known as gross profit percentage or gross margin ratio) is known and the relationship between gross profit and sales remains stable over time. This method also assumes the following: «The beginning inventory plus purchases equal total goods to be accounted for. « If sales, reduced to cost, are deducted from the sum of the opening inventory plus purchases, the result is the ending inventory. * Goods not sold must:be on hand. From these assumptions, we can recall the cost of sales formula as follows: Beginning inventory Pxx Purchases, net _xx Total goods available for sale xX Ending inventory (xx) Cost of sales Pxx Under normal circumstances, the amount of beginning and ending inventory is based on physical count. The net purchases amount is based on recorded transactions. Now consider the following:i ts nancial statements. man-made or Inventory is destroyed by fire, flood and othe natural disasters. ss The entity suspects inventory theft perpetrated by emP The entity is required to prepare interim fi In those cases, the gross profit method is useful. ing i ‘ory can be From the cost of sales formula, the cost of ending inventory e estimated as follows: Beginning inventory res Purchases, net ne Total goods available for sale Cost of sales (ood Estimated ending inventory Pxx As mentioned earlier, the beginning inventory is normally based on the Physical count in the previous accounting period. Net purchases amount is based on recorded transactions for the period. The problem now is the computation of cost of sales. Computation of Cost of Sales The computation of cost of sales depends on the basis of the gross profit rate (GPR). : If the GPR is based on sales: Cost of sales = Net sales x Cost ratio Cost ratio = 1 - GPR GPR = Gross profit/Net sales If the GPR is based on cost: Cost of sales = Net sales/ (1 + GPR) GPR = Gross profit/Cost of sales GPR is normally based on sales since ‘markup’ is the term ifthe GPR is based ot cost. GPR based on sales OTe Spee puete 100% while GPR based on cost can, lever exceeChapter 3 - Estimating Inventories | 3-5 Illustration - Gross Profit Method Data from an entity’s records disclosed the following: Goods available for sale (GAS) P680,000 Sales 610,000 Sales returns and allowances 10,000 Gross profit rate 20% Required: 1. If the entity is required to prepare quarterly financial statements, compute the estimated cost of ending inventory. 2. If a fire occurred at the entity’s warehouse just before the year- end count of inventory was to take place, compute the estimated cost of inventory destroyed by fire assuming goods with selling price of P24,000. were not destroyed. 3. If the entity’s physical count revealed ending inventory with selling price of P192,000, compute the estimated cost of missing inventory. Solution to Requirement No.1 - Estimated cost of ending inventory — GP! in Sales PR Bi GAS * P680,000 | GAS 680,000 Cost of sales Cost of sales (P600,000* x .8) (480,000) | _(P600,000/1.2) 500,000) | Est. ending inventory 200,000 | Est. ending inventory _ P180,000 * P610,000 - P10,000. Do not deduct if sales allowance only. Solution to Requirement No. 2- Estimated fire loss GPR Based on Sales GPR Based on Cost GAS P680,000 | GAS 680,000 Cost of sales Cost of sales (P600,000 x .8) (480,000) (P600,000/1.2) (500,000) Est. ending inventory 200,000 | Est.-ending inventory 180,000 Cost of goods not Cost of goods not destroyed (P24,000 x .8) SEATING destroyed (P24,000/1.2) (_20, (20.000) Fire loss Fire loss3-6 |_ Intermediate Accounting Vol. 12022 Edition by. Ocampo, d cost of missing in ventory Solution to Requirement No. 3 — Estimate GPR Based on Sales GAS 680,000 | GAS P680,000 Cost of sales Cost of sales oct Pe )0/1.2: (P600,000 x .8) (P600,000/: ) 780,000 480,01 Est. ending inventory 200,000 | Est. ending inventory Cost of EI based on Cost of EI based on | 0. count (P192,000/1.2) (160,000 count (P192,000 x .8) a, Est. missing inventory 46,400 _| Est. missing inventory _P.20,000 Disadvantages of Gross Profit Method ful in certain circumstances but not d_ financial reporting purposes. This hysical inventory must be taken is really on hand. The gross profit method is usel normally acceptable for year-en method provides only an estimate so pI at least once to determine that the inventory | This method uses past percentages in determining the markup and it may result in inaccurate estimate if significant fluctuations occur. Also, applying a blanket gross profit rate may not be appropriate if an entity has inventory items with widely varying gross profit rates. RETAIL INVENTORY METHOD PAS 2 allows the use of techniques for the measurement of the cost of inventories for convenience if the results approximate cost. One such technique is the retail inventory method. The retail method is often used in the retail industry for measuring inventories of large numbers of rapidly changing items with ‘similar margins for which it is impracticable to use other costing methods. This method is based upon an observable pattern between cost and sales price that exists in most retail concerns. Under this method, an entity must keep a record of the following: total cost and retail value of goods purchased; «total cost and retail value of the goods available for sale; and «sales for the period.hy Chapter 3 - Estimating Inventories | 3-7 To estimate the ending inventory, the retail inventory method uses a formula similar to the gross profit method as follows: Beginning inventory (at retail) Pxx Purchases, net (at retail) xX Total goods available for sale (at retail) xx Sales (at retail) Lod Estimated ending inventory (at retail) Pxx But unlike the gross profit method, the amounts are stated at retail. The cost of the inventory is determined by reducing the sales value of the inventory by the appropriate percentage gross margin: Estimated ending inventory (at retail) Pxx Profit margin (0), Estimated ending inventory (at cost) Pxx Alternatively, \ Estimated ending inventory (at retail) X cost-to-retail ratio Estimated ending inventory (at cost) Cost-to-Retail Ratio The cost-to-retail ratio is computed as follows: Goods available for sale (at cost) Pxx / Goods available for sale (at retail) Pxx Cost-to-retail ratio —% The items to be included in the numerator and denominator will depend on whether the entity uses FIFO or average cost formula. The only difference is the treatment of the beginning inventory. The beginning inventory is excluded in the computation under FIFO retail method and the entity computes the cost-to-retail ratio for the current period. purchases only. The beginning inventory is included in the computation under average retail method. Therefore, the cost-to- retail ratio is the same under both methods if there is no beginning inventory. So assuming no beginning inventory, the treatment of the items in computing cost-to-retail ratio under both FIFO and average retail method is summarized as follows:3-8 |_Intermediate Accounting Vol. I 2022 Edition by R_R_OCaMPO Cost Retai Purchases XX Ee Purchase returns (xx) (ox) Purchase allowances (xx) = Purchase discounts (xx) = Freight in XX = Departmental transfer in Xx Xx Departmental transfer out (xx) (xx) Markups?® 2 bis Markup cancellations : (xx) Markdowns* : (xx) Markdown cancellations shan Xx Normal shortages® ae e ‘Abnormal shortages (xx) Go) Goods available for sale xx xx ® Original selling price (Purchases at cost + Initial markup) ' ® Increase in original selling price © Decrease in original selling price * Breakage, damage, theft, shrinkage or similar items Conventional Retail Inventory Method This method is designed to approximate the lower of average cost or market. That is why it is also known as the’lower of cost or market approach. This method excludes net markdowns in computing the cost-to-retail ratio. To yield an estimate that approximates cost, PAS 2 requires that the percentage used takes into consideration inventory that has been marked down to below its original selling price. Therefore, the conventional retail inventory method is no longer allowed,Chapter 3 - Estimating Inventories _|_3-9 Ending Inventory at Retail As noted earlier, the ending inventory at retail is computed as follows: Total goods available for sale (at retail) Pxx Sales (at retail) to Estimated ending inventory (at retail) Pxx The following items complicate the computation of ending inventory at’ retail and are treated as follows depending on whether sales are recorded gross or net: Gross Sales | Net Sales | Sales returns _ (xx) E | Sales allowances = xX Sales discounts a xX, Employee discounts xx XX Normal shortages xX xx Abnormal shortages E = Net deduction from GAS xx xX