Basic Concepts

Definition
According to PAS 2, Inventories are assets:
a) Held for sale in the ordinary course of business.
b) In the process of production for such sale.
c) In the form of materials or supplies to be consumed in the production process or in the
rendering of service

Classes of Inventories – vary in accordance with the entity’s nature of business.

1. Merchandising business – Merchandise Inventories (definition (a) above).
2. Manufacturing business – Finished Goods Inventories (definition (a) above); Work in
Process Inventories (definition (b) above); Raw Materials Inventories and Factory
Supplies (definition (c) above).
3. Service business – Work in Progress Inventories (definition (b) above).

Recognition
Inventories are recorded as assets and are reported in the balance sheet when the following
conditions are met:
a. It is possible that the future economic benefits associated with the inventories will flow
to the enterprise.
b. The inventories have cost, or value that can be measured reliably. But the real
question is what goods shall be included in inventory? “All goods to which the entity
has the title shall be included in inventory, regardless of location.”

Notes regarding exceptions:

a. In a sale or return agreement, if the goods are unsalable or the buyer has the intention
of returning it, good are not recognized on the books of the buyer.
b. In a sale on trial or approval, the goods are not recognized on the books of the seller if
the buyer signified approval or if the goods are not returned within a reasonable time
after the allowed period elapsed; it is recorded on the books of the buyer.

Frequently Asked Question on Recognition:

Inventory Cut-Off
The following steps are undertaken in applying inventory cut-off.
1. Determine whether the inventory should be included or excluded (use the above
concepts).
2. Determine whether sales or purchases is recorded. The recording of sales or accounts
receivable is generally manifested y the issuance or recording of sales invoice. On the
other hand, the recording purchases, or accounts payable is usually manifested by the
receipt or recording of purchase invoice.
3. Determine whether the inventories are included or excluded. If the problem did not
indicate whether the goods have been included or excluded, the following assumptions
are used:
a. All sale DELIVERIES made ON OR BEFORE COUNT DATE is INLCUDED in the count.
b. All RECEIPTS of goods ON OR BEFORE COUNT DATE is INCLUDED in the count, All
receipts AFTER COUNT DATE are EXCLUDED form the count. The above rule is
subject to contradicting evidence stated in the problem.

Notes:
1. FIFO Method and Average Method are used for homogenous or interchangeable
inventories while specific identification is used for heterogenous or non-
interchangeable inventories.
2. Last in, first out is NOT ALLOWED ANYMORE by PAS 2.

Cost Formulas
1. First in, First out Method – this method assume that the items of inventory which are
purchased first are sold and the ending inventory are presented by the most recent
purchases. FIFO costing method may be used with PERPETUAL or PERIODIC system
 and regardless o the system used, the cost of the ending inventory and cost of goods
sold are the same.

Solution Guide:
a. Ending inventory – (inventory, end quantity x cost of latest purchases) If the
quantity purchased based on the most recent transaction is not enough, the cost
of te next latest purchase is used until the entire ending inventory quantity has
been assigned cost to.
b. Cost of Goods Sold – (inventory sold in quantity x cost of oldest purchases) If the
quantity purchased based on the oldest transaction is not enough, the cost of the
next oldest purchase is used until the entire quantity sold has been assigned cost
to.

2. Average Method – under this method, the cost of each item is determined from the
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.
 Average method may be used with PERIODIC SYSTEM and most known as
WEIGHTED AVERAGE METHOD.

Solution Guide:
a. Ending inventory – (inventory, end quantity x weighted average unit cost)
b. Cost of Gods Sold – (inventory sold in quantity x weighted average unit cost.

NOTE: Weighted average cost is RECOMPUTED ONCE EVERY YEAR and computed as
TGAS in total / TGAS in units

 Average method may be used with PERPETUAL SYSTEM and most known as
MOVING AVERAGE METHOD

Solution Guide:
a. Ending Inventory – (inventory, end quantity x latest moving average unit
cost)
b. Cost of Goods Sold – (inventory sold in quantity x latest moving average unit
cost)

NOTE: Under this costing method, the average unit cost is RECOMPUTED after EVERY
PURCHASE TRANSACTION (it includes purchase returns transactions), so that whatever
the last moving average unit cost (after the last purchase transaction) shall be
assigned as cost of ending inventory and cost of goods sold.

Net Realizable Value (NRV)

Concept of NRV
Measuring inventories at the lower o cost or NRV is in line with the basic accounting
concept that an asset shall not be carried at an amount in excess of amounts it is expected
to be realized (recoverable amount).

So, if:
Cost > NRV = There is inventory write-down
Cost < NRV = There is reversal of inventory write-down if there is previous inventory write-
down

Determination of LCNRV
Lower of Cost or NRV (LCNRV) is applied on an ITEM-BY-ITEM BASIS. This is applied to all
types of inventories except for RAW MATRIALS AND FACTORY SUPPLIES. These items of
inventories are tested for possible write-down only if the related finished goods are to be
written.
Accounting for Inventory Write-down
Direct method
The inventory is recorded at the lower of cost or net realizable value. This method is
also known as “cost of goods sold” method because any loss on inventory write-down
is not accounted for separately but “buried” in the cost of goods sold.
Allowance method
The inventory is recorded at cost and any loss on inventory write-down is accounted
for separately. This method is also known as “loss method” because a loss account,
“loss on inventory write-down” is debited and a valuation account “allowance for
inventory write-down” is credited for the inventory write-down.

Notes:
1. The ending balance of allowance for inventory write-down is the difference between
cost and NRV of the current end of accounting period.
2. Loss on inventory write-down is presented as addition to COGS or other losses if
immaterial.
3. Gain on reversal of inventory write-down is up to extent of allowance balance only and
presented as deduction against COGS.

Other Related Topics

Purchase Commitments – are obligations of an entity to acquire certain goods sometime in
the future at a fixed price and fixed quantity.
A purchase order has already been made for future delivery of goods in fixed price and
fixed quantity.
A contracting party under a purchase commitment cannot cancel the contract without
suffering a penalty. Thus, the buyer must accept future delivery even if the goods
promised to be purchased become impaired (there is a decrease in price). In such
case, the buyer recognized loss on purchase commitments.
When prices subsequently increase, the buyer recognizes gain on purchase
commitment but up to the extent only of the loss previously recognized.

Inventory Estimation
Why there is a need for inventory estimation?
Impossibility of Physical Count
Cost-benefit Constraint
Proof of the reasonable accuracy of a physical count

Notes:
1. COGS at retail computed as: Gross sales less sales return add employees discount and
normal losses. As we can see, only sales returns are deducted.
2. COGS at cost is computed as TGAS at cost less ending inventory at cost.
3. Estimated ending inventory at cost is computed as (Ending inventory at retail x cost
ratio).
4. Cost ratio varies depending on the retail inventory method used:
 Under Average Method: (TGAS @ COST / TGAS @ RETAIL)
 Under FIFO method: (TGAS @ COST – BEG. INVENTORY @ COST) / (TGAS
@ REATIL – BEG. INVENTORY @ REATIL)
 Under Conservative Method: (TGAS @ COST / TGAS @ RETAIL = NET
MARKDOWNS)
5. Retail inventory method ay be used to estimate inventories for INTERIM REPORTING
purposes and ACCEPRABLE for ANNUAL REPORTING.
FS Presentation of Inventories – Inventories are reported in the Statement of Financial
Position under CURRENT ASSETS section.

Disclosure Requirements
With respect to inventories, the financial statements shall disclose the following:
a. The carrying amount of inventories pledged as security for liabilities
b. The circumstances or events that led to the reversal of a write-down of inventories
c. The amount of reversal of write-down of inventories recognized as an expense during
the period
d. The amount of any write-down of inventories recognized as an expense during the
period
e. The amount of inventories recognized as an expense during the period
f. The carrying amount of inventories carried at fair value less cost to sell
g. The total carrying amount of inventories and the carrying amount in classifications
appropriate to the entity. Common classifications of inventories are merchandise
inventory, raw materials, goods in process, finished goods, and production supplies
h. The accounting policy adopted in measuring inventories, including the cost formula
used