TOA-03

THEORY OF ACCOUNTS
INVENTORIES

PAS 2 paragraph 6: 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.

Two Classes of Inventories:

1. Inventories of a TRADING ENTITY – merchandise inventory
2. Inventories of a MANUFACTURING ENTITY:
a. Finished goods
b. Goods in process
c. Raw materials
d. Factory or manufacturing supplies

Terms related to purchase of inventories:

1. FOB destination – ownership transferred to buyer upon receipt of inventory
2. FOB shipping point - ownership transferred to buyer upon shipment of inventory
3. Freight collect – buyer pays freight
4. Freight prepaid – seller pays freight

Maritime Shipping Terms:

1. FAS or free alongside – seller must bear all expenses and risk involved in delivering the goods up to the dock
next to or alongside the vessel on which the goods are to be shipped; buyer bears the cost of loading and
shipment; title passes to the buyer when the carrier takes possession of the goods
2. CIF or cost, insurance and freight – buyer agrees to pay in a lump sum the cost of the goods insurance cost and
freight charge; seller pays for the cost of loading; title passes to buyer upon delivery of goods to carrier
3. Ex-ship – seller bears all expenses and risk of loss until goods are unloaded at which time title and risk of loss
passes to the buyer

Consigned goods – included in the consignor’s inventory and excluded from the consignee’s inventory.

Two Systems of Accounting for Inventories:

1. Periodic or physical system – cost of goods sold is computed only at the end of the period by deducting the
physical inventory from the total cost of goods available for sale; generally used when the individual inventory
items have small peso investment.
2. Perpetual system – cost of goods sold is computed at the time of every sale; commonly used when the inventory
items treated individually have large peso investment.

Cash Discounts (Purchase Discount and Sales Discount) – reductions in the invoice price allowed only when payment is
made within the discount period; recorded.

Trade Discounts – reductions in the list price or catalog price in order to get the invoice price; NOT recorded.

Two Methods of Recording Purchases:

1. Gross method – purchases recorded at gross amount of the invoice; purchase discounts deducted from
purchases when computing for the COGS.
2. Net method – purchases recorded at net amount, whether discounts are taken or not taken; PDL treated as
other expense.

Cost of Inventory:
1. Cost of purchase – purchase price, import duties and irrevocable taxes, freight, handling and other direct costs;
does not include foreign exchange differences
2. Cost of conversion – DM, DL, FOH
3. Other cost incurred in bringing the inventory to its present location and condition

Costs excluded from the cost of inventory: abnormal wastage, storage costs, administrative overheads, distribution
costs.

Storage costs related to goods in process is inventoriable.

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INVENTORY COST FLOW

The following are the cost flow assumptions acceptable under IFRS:
1. FIFO – this method favors the SOFP in that the inventory is stated at current replacement cost; the objection to
this method is that there is improper matching of cost against revenue because the goods sold are stated at
earlier or older prices resulting in understatement of COGS.
2. Weighted average
a. Periodic – weighted average unit cost is computed by dividing the total costs of beginning inventory and
purchases over the total units in beginning inventory and purchased during the period.
b. Perpetual – also known as moving average method; a new weighted average unit cost is computer after
every purchase and purchase return; this method requires the use of stock cards to monitor the unit
costs
3. Specific identification – in this method, the flow of the inventory cost corresponds with the actual physical flow
of goods; costly to implement

INVENTORY VALUATION
PAS 2 paragraph 9: valuation is at LCNRV
PAS 2 paragraph 25: cost of inventories shall be determined using: FIFO method or Weighted Average method
PAS 2 paragraph23: if inventories are not ordinarily interchangeable, Specific Identification method can be used

Net realizable value = selling price in ordinary course of business less estimated cost of completion and estimated selling
costs

Methods of Accounting for Inventory Writedown to NRV:

1. Direct method – inventory is recorded at the LCNRV; any loss on inventory writedown is “buried” in the cost of
goods sold
2. Indirect/Allowance method – inventory is recorded at COST; any loss on inventory writedown is accounted for
separately through the use of an allowance account; loss on inventory writedown is included in the computation
of cost of goods sold
a. If required allowance increases – additional loss is recognized
b. If required allowance decreases – gain on reversal of inventory writedown is recorded only to the extent
of the allowance balance; gain is included in the cost of goods sold as a deduction

Relative Sales Price method of inventory measurement is used when different commodities are purchased at a
lumpsum and the single cost is apportioned among the commodities based on their respective sales price.

Standard Costs – predetermined product costs established on the basis of normal levels of materials and supplies, labor,
efficiency and capacity utilization. PAS 2, paragraph 21 states that the standard cost method may be used for
convenience if the results approximates cost.

Purchase Commitments – are obligations of an entity to acquire certain goods sometime in the future at a fixed price
and fixed quantity.
 If there is a decline in purchase price after a noncancelable purchase commitment has been made, a loss
is recorded in the period of the price decline
 If the market price rises by the time the entity makes the purchase, a gain on purchase commitment
would be recorded; gain to be recognized is limited to the loss on purchase commitment previously
recorded

Some disclosure requirements for inventories:

 Accounting policy adopted in measuring inventories
 Total carrying amount of inventories and the carrying amount in classifications appropriate to the entity
 Carrying amount of inventories carried at fair value less cost to sell
 Amount of inventories recognized as an expense during the period
 Amount of any writedown of inventories
 Amount of reversal of writedown recognized as income
 Circumstances or events leading to the reversal of a writedown of inventories
 Carrying amount of inventories pledged as security for liabilities

INVENTORY ESTIMATION

Reasons for making an estimate of inventory:

1. Determination of inventory loss due to fire and other catastrophe or theft of merchandise
2. Proof of reasonable accuracy of a physical count (gross profit test)
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3. Preparation of interim statements or statements of less than 1 year.

Two methods of Inventory Estimation:

1. Gross Profit Method – ending inventory is computed as “goods available for sale minus cost of sales”. The cost
of sales is determined through the use of the gross profit rate. The major assumption of this method is that the
GP rate remains approximately the same from period to period.
2. Retail Inventory Method – ending inventory is computed by:
a. Goods available for sale at selling price minus net sales equals ending inventory at selling price which is
multiplied by the cost ratio to get the inventory at cost.
b. The cost ratio under the retail method is computed by dividing the goods available for sale at cost by the
goods available for sale at selling price.

Four Approaches of the Retail Inventory Method:

1. Conservative approach – the cost ratio is determined including markups and excluding markdowns in computing
the goods available for sale at retail. This is also known as the Conventional or Lower of Average Cost or Market
Approach.
2. Average Cost approach – the markups and markdowns are both included in the computation of the cost ratio.
3. FIFO approach – a cost ratio is computed for the current year. Only current purchases are considered together
with markups and markdowns. The beginning inventory is excluded in the computation.
4. LIFO approach – the cost ratio is computed following the same procedure under FIFO approach.

Terms under the Retail Inventory Method:

1. Original retail - sales price at which the goods are first offered for sale
2. Initial markup – original markup on the cost of goods or the amount added to the original cost to get the original
retail price
3. Additional markup – an increase in the sales price above the original sales price or the amount added to the
original retail price
4. Markup cancelation – a decrease in the sales price that does not reduce the sales price below the original sales
price
5. Net markup – additional markup minus markup cancelation
6. Markdown – a decrease in the sales price below the original price
7. Markdown cancelation – an increase in sales price that does not raise the sales price above the original sales
price
8. Net markdown – markdown minus markdown cancelation

MULTIPLE CHOICE:

1. Which of the following are accounted for under PAS 2?

I. The cows of a cattle farmer
II. The gold mineral reserves of a mining company
III. Work-in-progress of a long-term construction contract
IV. Maturing wine in the cellars of a wine produces
V. Clothing in the warehouse of a retailer
VI. Lumber of a wood distributor
a. III, IV, V, and VI c. II, III, IV, V and VI
b. IV, V, and VI d. I, II, III, IV, and VI

2. In which of the following circumstances would an inventory writedown be recognized or reversed?

I. When inventory is damaged or has become obsolete and can no longer be used
II. When prices of specific raw materials have declined but the prices of the related
finished product remain above its costs to complete.
III. When the selling price less the selling costs of a finished product (NRV) is less
than its carrying value
IV. When at year-end a company anticipates that market prices will recover for
inventory that is currently carried at net realizable value
a. I and III c. I, III, and IV
b. I, II and III d. I, II, III and IV

3. Angel-Loves-Me Co. is a clothing retailer. Which of the following costs would it record as a cost of purchase?
I. Cost to ship the jeans from a supplier to the warehouse
II. Cost to ship the jeans from the warehouse to a retail store
III. Reimbursable import duties
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IV. Storage costs to the jeans while in transit to the warehouse
V. Salary of the purchasing manager in the accounts department
a. I, II, and IV c. I, II, III and IV
b. I, II, and III d. I, II, III, IV and V

4. How should cash discounts that are received from the purchase of inventory be recognized?
a. Financial revenue
b. Reduction of the cost of inventory
c. It has no impact of the measurement of inventory
d. None of the above

5. The USA segment of International, Inc. measures raw material inventory using the FIFO method. Its European
segment measures the same raw material inventory using the weighted average cost method. Is this permitted under
PAS 2?
a. No. Cost formulas should be consistently applied to al inventories similar in
nature
b. Yes. Different cost formulas can be applied to all inventories similar in nature as
long as the methods used are either FIFO or the weighted average
c. No. PAS 2 requires all inventories to be measured using the specific identification
cost formula
d. None of the above

6. Why is WIP arising out of construction contracts outside the scope of PAS 2?
a. WIP arising out of construction contracts is not inventory
b. There is a specific standard dealing with WIP arising out of construction contracts
(PAS11)
c. Contract costs may fall into different accounting periods
d. None of the above

7. Which of the following statements are correct?

I. Upon the sale of inventory, an entity must recognize an expense for the carrying
amount of the inventory.
II. Inventories can be allocated to other asset accounts
III. The amount of any writedown of inventory should be deferred and amortized
IV. LIFO can be used as a cost formula to measure inventory in PAS 2
V. Allocation of fixed overhead to inventory is based on the normal capacity of the
production facilities
VI. Unallocated overheads are deferred so they can be allocated in future periods
a. I, II, and V c. II, V, and VI
b. I, III and IV d. I, III and V

8. Which of the following are most likely to be classified as components of inventory of an accounting firm prior to
revenue being recognized under PAS 18?
I. Salaries of the client service accountants
II. Costs of brochures sent directly to clients
III. Travel costs to client locations
IV. An allocation of salary costs of technology support staff assisting client service
accountants
V. An allocation of salary costs of the firm’s accounts payable clerk
VI. Costs of materials used to prepare client’s reports
a. I, III, IV, and VI c. I, II, IV, V, and VI
b. I, II, III, and IV d. I, II, III, IV, and Vi

9. Inventories do not include

a. Finished goods produced
b. Merchandise purchased by a retailer and held for resale
c. Land and other property held for resale by a real estate developer
d. Abnormal amounts of wasted materials, labor and other production costs

10. The cost of inventories should include the following except

a. Cost purchase
b. Cost of conversion
c. Other costs incurred in bringing the inventories to their present location and
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condition
d. Selling costs

11. Which of the following is not included in the cost of purchase of inventory?
a. Purchase price
b. Import duties and other taxes
c. Freight, handling and other costs directly attributable to the acquisition of goods
d. Trade discounts, rebates and other similar items

12. Which of the following is not included in the cost of conversion of inventory?
a. Direct labor c. Variable factory overhead
b. Fixed factory overhead d. Administrative overhead

13. Freight and other handling charges incurred in the transfer of goods from the consignor to consignee are
a. Inventoriable by the consignor
b. Inventoriable by the consignee
c. Expense on the part of the consignor
d. Expense on the part of the consignee

14. The use of a discount lost account implies that the cost of a purchased inventory item is its
a. Invoice price
b. List price
c. Invoice price less the purchase discount taken
d. Invoice price less the purchase discount available whether or not taken

15. How should the following costs affect a retailer’s inventory?

Freight In Interest on Inventory Loan
a. Increase No effect
b. Increase Increase
c. No effect Increase
d. No effect No effect

16. When a portion of inventories has been pledged as security on a loan

a. The cost of the pledged inventories should be transferred from current assets to
noncurrent assets.
b. The value of the portion pledged should be subtracted from the debt
c. The fact should be disclosed but the amount of current assets should not be
affected
d. An equal amount of retained earnings should be appropriated

17. Goods on consignment should be included in the inventory of

a. The consignor but not the consignee
b. Both the consignor and the consignee
c. The consignee but not the consignor
d. Neither the consignor nor the consignee

18. Metrogate Company paid the in-transit insurance premium for consignment goods shipped to Awo Company, the
consignee. In addition, Metrogate advanced part of the commission that will be due when Awo sells the goods. Should
Metrogate inclue in-transit insurance premium and advance commission in inventory costs?
Insurance Premium Advanced Commission
a. Yes Yes
b. No No
c. Yes No
d. No Yes

19. The credit balance that arises when a net loss on a purchase commitment is recognized should be
a. Presented as a current liability
b. Subtracted from ending inventory
c. Presented in the income statement
d. Presented in the statement of changes in equity

20. What is the method of accounting for inventories in which the cost of goods sold is recorded each time a sale is
made?
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a. No inventory system c. Perpetual inventory system
b. Periodic inventory system d. Planned inventory system

21. FOB destination means

a. The ownership of the goods is transferred upon shipment of the goods and the
buyer is the owner of the goods in transit
b. The seller must bear all expense and risk involved in delivering the goods to the
dock next to the vessel on which they are to be shipped. The buyer bears the cost
of loading and of shipment, thus title passes when the carrier takes possession of
the goods
c. The ownership of goods in transferred upon receipt of the goods by the buyer at
the point of the destination and the seller is the owner of the goods in transit
d. The freight charge is paid by the seller but chargeable to the buyer

22. Which of the following describes the agreement that the buyer will pay for the freight charge but is not legally
responsible for the same?
a. FOB destination, freight prepaid
b. FOB destination, freight collect
c. FOB shipping point, freight prepaid
d. FOB shipping point, freight collect
23. This cost formula must be employed for inventories that are not ordinarily interchangeable, and those goods and
services produced and segregated for specific projects.
a. Specific identification c. Net realizable value
b. Standard cost d. FIFO
24. Which inventory pricing method would reflect the most recently incurred purchase costs in the ending inventory?
a. FIFO c. Weighted-average
b. LIFO d. Retail

25. The unique characteristic of this costing method is that cost of goods sold is the same under a periodic system as
under a perpetual system
a. FIFO c. LIFO
b. Specific identification d. Weighted-average

26. In a period of declining price, which of the following methods would result to the most conservative net income?
a. FIFO c. Weighted-average
b. LIFO d. Specific identification

27. Total cost of goods available for sale during the period divided by the total units available for sale during the period
equals an average unit cost. Ending inventory and cost of goods sold are then priced at this average cost
a. Weighted-average (periodic) c. Specific identification
b. Weighted-average (perpetual) d. LIFO

28. The average inventory pricing method under a perpetual inventory system is called
a. Weighted-average method c. Simple average method
b. Moving average method d. Composite average method

29. Which method of inventory pricing best approximates specific identification of the actual flow of costs and units in
most manufacturing situations?
a. Weighted-average c. LIFO
b. FIFO d. Moving average

30. What is meant by “net realizable value”?

a. Current replacement cost
b. Estimated selling price
c. Estimated selling price less estimated cost to complete
d. Estimated selling price less estimated cost to complete and estimated cost to sell

31. A major advantage of the retail inventory method is that it

a. Hides costs from customers and employees
b. Gives a more accurate statement of inventory cost that other methods
c. Permits companies which use it to avoid taking an annual physical count
d. Provides a method for inventory control and facilities determination of the
periodic inventory
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32. When the conventional retail inventory method is used, markdowns are commonly ignored in the computation of
the cost-to-retall ratio because
a. There may be no markdowns in a given year
b. This tends to give a better approximation of the lower of cost or market
c. Markups are also ignored
d. This tends to result in the showing of a normal profit margin in a period when no
markdown goods have been sold

33. If the conventional retail inventory method is used, which of the following calculation would include or exclude net
markdowns?
Cost-to-retail ratio Ending inventory at retail
a. Include Include
b. Include Exclude
c. Exclude Include
d. Exclude Exclude

34. The gross profit method of estimating ending inventory may be used for all of the following, except
a. Rough test of the validity of an inventory cost determined under either periodic
perpetual system
b. Internal as well as external year-end reports
c. Internal as well as external interim reports
d. Estimates of inventory destroyed by the fire of other casualty