Chapter 10 – Inventories Factory or manufacturing supplies

 similar to raw materials but their relationship to the end

Inventories product is indirect.
 Assets held for sale in the ordinary course of business,  These may be referred to as indirect materials because
in the process of production for such or in the form of they are not physically incorporated in the products
materials or supplies to be consumed in the production being manufactured
process or in the rendering of services  There are other manufacturing supplies like paint and
 Encompass goods purchased and held for resale: nails which become part of the finished product.
o Merchandise purchased by a retailer and held  However, since the amounts involved are insignificant,
for sale it is impractical to attempt to allocate their cost directly
o Land and other property held for resale by a to the product.
subdivision entity and real estate developer  These supplies find their way into the product cost as
 Also encompass finished goods produced, goods in part of the manufacturing overhead.
process and materials and supplies awaiting use in the
production process Goods includible in the inventory
 As a rule, all goods to which the entity has title shall be
Classes of Inventories included in the inventory, regardless of location.
 Inventories of a trading concern – one that buys and  The phrase passing of title is a legal language which
sells goods in the same form purchased. The term means the point of time at which ownership changes
merchandise inventory is generally applied to goods
held by a trading concern Legal test
 Inventories of manufacturing concern – one that  Is the entity the owner of the goods to be inventoried?
buys goods which are altered or converted into another  If the answer is in the affirmative, the goods shall be
form before they are made available for sale. The included in the inventory
inventories of a manufacturing concern are:  If the answer is in the negative, the goods shall be
o Finished goods excluded from the inventory
o Goods in process
o Raw materials Applying the legal test, the following items are included in
o Factory or manufacturing supplies inventory:
a) Goods owned and on hand
Definitions b) Good in transit and sold FOB destination
c) Goods in transit and purchased FOB shipping point
Finished good d) Goods out on consignment to consignee
 completed products which are ready for sale. These e) Goods in the hands of salesmen or agents
have been assigned their full share of manufacturing f) Goods held by customers on approval or on trial
costs
Exception to the legal test
Goods in process or work in process  Installment contracts may provide for retention of title
 partially completed products which require further by the seller until the selling price is fully collected
process or work before they can be sold  Following the legal test, the goods sold on installment
bases are still the property of the seller and therefore
Raw materials normally includible in his inventory
 goods that are to be used in the production process.  However, in such a case, it is an accepted accounting
No work or process has been done on them as yet by the procedure to record the installment sale as a regular
entity inventorying them. sale on the part of the seller and as a regular purchase
 Broadly, raw materials cover all materials used in the on the part of the buyer
manufacturing operations.  Thus, the goods sold on installment are included in the
 However, frequently raw materials are restricted to inventory of the buyer and excluded from that of the
materials that will be physically incorporated in the seller, the legal test to the contrary notwithstanding.
production of other goods and which can be traced  This is a clear example of economic substance prevailing
directly to the end product of the production process. over legal form.
Who is the owner of goods in transit? CIF or Cost, insurance and freight – Under this shipping
 The ownership of goods in transit depends on the terms, contract, the buyer agrees to pay in a lump sum the cost of
whether FOB destination or FOB shipping point. FOB goods, insurance cost and freight charge. This shipping
means free on board contract may be modified as FG which means that the buyer
 Under FOB destination, ownership of goods purchased agrees to pay in a lump sum the cost of the goods and freight
is transferred only upon receipt of the goods by the buyer charge only. In either case, the seller must pay for the cost of
at the point of destination. Thus, the goods in transit loading. Thus, title and risk of loss shall pass to the buyer
are still the property of the seller. Accordingly, the seller upon delivery of the goods to the carrier.
shall legally be responsible for freight charges and other Ex-ship – A seller who delivers the goods ex-ship bears all
expenses up to the point of destination expenses and risk of loss until the goods are unloaded at
 Under FOB shipping point, ownership is transferred which time title and risk of loss shall pass to the buyer
upon shipment of the goods and therefore, the goods in
transit are the property of the buyer. Accordingly, the Consigned goods
buyer shall legally be responsible for freight charges and  Consignment is a method of marketing goods in which
other expenses from the point of shipment to the point of the owner called the consignor transfers physical
destination. possession of certain goods to an agent called the
 In practice, during the accounting period, the consignee who sells them on the owner’s behalf
accountant normally records purchases when goods are  Consigned goods shall be included in the consignor’s
received and sales when goods are shipped, regardless inventory and excluded from the consignee’s inventory
of the precise moment at which title passed.  Freight and other handling charges on goods out on
 This procedure is expedient and no material consignment are part of the cost of goods consigned
misstatements occur in the financial statements  When consigned goods are sold by the consignee, a
because title usually passes in the same accounting report is made to the consignor together with a cash
period. remittance for the amount of sales minus commission
 However, the accountant should carefully analyze the and other expenses chargeable to the consignor
invoice terms of goods that are in transit at the end of
the accounting period to determine who has legal title. For example, a consignee sells consigned goods for
 Accordingly, adjustments are in order if errors are P100,000. This amount is remitted to the consignor less
committed in recording purchases and sales. commission of P15,000 and advertising of P2,000.

Freight terms The consignor simply records the cash remittance from the
Freight collect – means that the freight charge on the consignee as follows:
goods shipped is not yet paid. The common carrier shall Cash 83,000
collect the same from the buyer. Thus the freight charge is Commission 15,000
actually paid by the buyer if the term is freight collect Advertising 2,000
Freight prepaid – means that the freight charge on the Sales 100,000
goods shipped is already paid by the seller
 The term FOB destination and FOB shipping point Incidentally, consigned goods are recorded by the consignor
determine ownership of the goods in transit and the by means of a memorandum entry
party who is supposed to pay the freight charge and
other expenses from the point of shipment to the point Statement presentation
of destination  Inventories are generally classified as current assets
 The term freight collect and freight prepaid  The inventories shall be presented as one line item in
determine the party who actually paid the freight the statement of financial position but the details of the
charge but not the party who is supposed to legally pay inventories shall be disclosed in the notes to financial
the freight charge. statements
 For example, the note shall disclose the composition of
Maritime shipping terms the inventories of a manufacturing entity as finished
FAS or free alongside – a seller who ships FAS must bear goods, goods in process, raw materials and
all expenses and risk involved in the delivering the goods to manufacturing supplies
the dock next to or alongside the vessel on which the goods
are to be shipped. The buyer bears the cost of loading and
shipment and thus, title passes to the buyer when the
carrier takes possession of the goods.
 Trade discounts and cash discounts
Accounting of inventories Trade discounts
 Two systems are offered in accounting for inventories,  Deductions from the list or catalog price in order to
namely periodic system and perpetual system arrive at the invoice price which is the amount actually
charged to the buyer
Periodic system  Thus trade discounts are not recorded
 Calls for the physical counting of goods on hand at the  The purpose of trade discounts is to encourage trading
end of the accounting period to determine quantities. or increase sales. This also suggest to the buyer the price
The quantities are then multiplied by the corresponding at which the goods may be resold
unit costs to get the inventory value for balance sheet
purposes. Cash discount
 This approach gives actual or physical inventories  Deductions form the invoice price when payment is
 This is generally used when the individual inventory made within the discount period. The purpose of cash
items have small peso investment, such as groceries, discount is to encourage prompt payment
hardware and auto parts.  These are recorded as purchase discount by the buyer
and sales discount by the seller
Perpetual system  Purchase discount is deducted from purchases to arrive
 Requires maintenance records called stock cards that at net purchases and sales discount is deducted from
usually offer a running summary of the inventory inflow sales to arrive at net sales revenue
and outflow
 Inventory increases and decreases are reflected into Illustration – page 296
stock cards and the resulting balance represents the
inventory. Methods of recording purchases
 This approach gives book or perpetual inventories 1. Gross method – purchases and accounts payable are
 This is commonly used where the inventory items recorded at gross amount of invoice
treated individually represent a relatively large peso 2. Net method – purchases and accounts payable are
investment such as jewelry and cars recorded at net amount of the invoice
 In an ideal perpetual system, the stock cards are kept to
reflect and control both units and costs Illustration – page 296-297
 Consequently, the entity would be able to know the
inventory on hand at a particular moment in time Gross method vs Net method
 In recent years, the widespread use of computers has  The cost measured under the net method represents the
enabled practically all large trading and manufacturing cash equivalent price on the date of payment and
entities to maintain a perpetual inventory system. With therefore the theoretically correct historical cost.
computers, the entities can conveniently and effectively However, in practice, most entities record purchases at
store and retrieve large amount of inventory data gross invoice amount
 When the perpetual system is used, a physical count of  Technically, the gross method violates the matching
the units on hand should at least be made once a year principle because discounts are recorded only when
to confirm the balances appearing on the stock cards. taken or when cash is paid rather than when purchases
that gives rise to the discounts are made
Illustration: page 293-294  Moreover, this procedure does not allocate discounts
taken between goods sold and goods on hand
Inventory shortage or overage  Despite its theoretical shortcomings, the gross method is
 If at the end of the accounting period, a physical count supported on practical grounds
indicates a different amount, an adjustment is necessary  The gross method is more convenient than net method
to recognize any inventory shortage or overage. from a bookkeeping standpoint
 The inventory shortage is usually closed to cost of goods  Moreover, if applied consistently over time, the gross
sold because this is ofthen the result of normal method usually produces no material errors in the
shrinkage and breakage in inventory financial statements.
 However, abnormal and material shortage shall be
separately classified and presented as other expense Cost of inventories – the cost of inventories shall comprise:
a) Cost of purchase
b) Cost of conversion
c) Directly attributable cost incurred in bringing the
inventories to their present location and condition
Cost of purchase Allocation of variable production overhead
 Comprises the purchase price, import duties and  Variable production overhead is allocated to each unit
irrevocable taxes, freight, handling and other costs of production on the basis of the actual use of the
directly attributable to the acquisition of finished production facilities
goods, materials and services  A production process may result in more than one
 Trade discounts, rebates and other similar items are product being produced simultaneously. This is the
deducted in determining the cost of purchase case, for example, when joint products are produced or
 The cost of purchase shall not include foreign exchange where there is a main product and a by-product
differences which arises directly from the recent  When the cost of conversion are not separately
acquisition of inventories involving a foreign currency indentifiable, they are allocated between the products
 Moreover, when inventories are purchased with on a rational and consistent basis, for example, on the
deferred settlement terms, the differences between the basis of the relative sales value of each product
purchase price for normal credit terms and the amount  Most by-products by their nature are not material
paid is recognized as interest expense over the period  By products are measured at net realizable value and
of financing this value is deducted from the cost of the main product

Cost of conversion Directly attributable cost

 Includes cost directly related to the units of production  The cost of inventories incurred in bringing the
such as direct labor inventories to their present location and condition
 Also includes a systematic allocation of fixed and  For example, it may be appropriate to include the cost
variable production overhead that is incurred in of designing product for specific customers in the cost
converting materials into finished goods of inventories. However, the following costs are
 Fixed production overhead is the direct cost of excluded from the cost of inventories and recognized as
production that remains relatively constant regardless expenses in the period when incurred:
of the volume of production a. Abnormal amounts of wasted materials, labor and
o Examples are depreciation and maintenance of other production costs
factory building and equipment, and the cost b. Storage costs, unless necessary in the production
of factory management and administration process prior to a further production stage. Thus
 Variable production overhead is the indirect cost of storage costs on goods in process are capitalized but
production that varies directly with the volume of storage costs on finished goods are expensed
production c. Administrative overheads that do not contribute to
o Examples are indirect labor and indirect bringing inventories to their present location and
materials condition
d. Distribution or selling costs
Allocation of fixed production overhead
 The allocation of fixed production overhead to the cost Cost of inventories of a service provider
of conversion is based on the normal capacity of the  The cost of inventories of a service provider consists
production facilities primarily of the following:
 Normal capacity is the production expected to be a. Labor and other costs of personnel directly engaged
achieved on average over a number of periods or in providing the service, including supervisory
seasons under normal circumstances taking into personnel
account the loss of capacity resulting from planned b. Directly attributable overhead
maintenance  Labor and other costs relating to sales and general
 The amount of fixed overhead allocated to each unit of administrative personnel are not included but are
production is not increased as consequence of low recognized as expenses in the period incurred
production or idle plant
 Unallocated fixed overhead is recognized as expense in
the period in which it is incurred