JPIA – OMNISCIENTE

Accounting Group Tutorial

Intermediate Accounting 1
INVENTORIES
Inventories
• Are current assets held for sale in the ordinary course of business (finished goods)
• In the process of production for such sale (WIP)
• In the form of materials or supplies to be consumed in the production process or in the
rendering of services
Ordinary course of business refers to the necessary, normal or usual business activities of an
entity.
Examples of Inventories:
• Merchandise purchased by a trading entity and held for resale.
• Land and other property held for sale in the ordinary course of business
• Finished goods, goods undergoing production process by a manufacturing entity.
Finished Goods – are completed products which are ready for sale.
Goods in process/Work in process – are partially completed products which require further
process or work before they can be sold.
Raw materials – are goods that are to be used in the production process.

Ownership over Inventories

Regardless of location, an entity shall report in it's financial statements all inventories over which
it holds legal title to or obtained control of the related economic benefits.
Goods in Transit
Goods in transit pertain to goods already shipped by the seller but are not yet received by the
buyer. The lack of physical possession may pose a question on who owns the goods in transit.
▪ FOB Shipping point - ownership over the goods is transferred upon shipment. Therefore,
the goods in transit form part of the buyer's inventories. The buyer records the purchase
(and accounts payable) upon shipment.
▪ FOB Destination -ownership over the goods is transferred only when the buyer receives
the goods. Therefore, the goods in transit still part of the seller's inventories. The buyer
records the purchase (and accounts payable) inly when the goods are received.
Shipping Costs
a. Freight collect - freight is not yet paid upon shipment. The carrier collects shipping costs
from the buyer upon delivery. Thus, the buyer pays for the freight. However, this does not
mean that the buyer is the one who is supposed to pay for the freight.
b. Freight prepaid - the seller pays the freight in advance before shipment. However, this
does not mean that the seller is the one who is supposed to pay for the freight.
c. FAS (free alongside) - the seller assumes all expenses in delivering the goods to the
dock next to (alongside) the carrier on which the goods are to be shipped. The buyer
assumes loading and shipping costs. Title passes upon shipment to the carrier.
d. Ex-ship - the seller assumes all expenses until the goods are unloaded from the carrier,
at which time title passes to the buyer.
e. CIF (Cost, Insurance and Freight) - the buyer pays in lump sum the cost of the goods
and the insurance and freight costs.
f. CF (Cost and Freight) - the buyer pay in lump sum the cost of the goods and the freight
cost.
In either CIF or CF the seller must deliver the goods to the carrier and pay the costs of
loading. Thus, title passes to the buyer upon delivery of the goods to the carrier.
 Special accounting arises when...
Under FOB shipping point, freight prepaid, the buyer owns the goods being shipped but
the seller already paid the shipping costs.
Under FOB destination, freight collect, the seller owns the goods being shipped but the
carrier will be collecting the shipping costs from the buyer.

Illustration:
ABC Co. purchased goods with invoice price of P1,000 on account on December 27, 2011. The
related shipping cost amounted to P10. The seller
Shipped the goods on December 31, 2011. ABC Co. received the goods on January 2 , 2012 and
settled the account on January 5, 2012
The pertinent entries in the books of ABC Co. under the different terms of purchase are as follows:
A. FOB shipping point, freight collect
Dec. 31, 2011 Purchases 1,000
Accounts Payable 1,000
January 2, 2012 Freight-in 10
Cash 10
January 5, 2012 Accounts Payable 1,000
Cash 1,000
The buyer records the P10 freight cost (as “Freight in”) because the buyer is the one who is
supposed to pay for the freight. Under FOB shipping point, the buyer owns the goods in the transit.
B. FOB destination, freight prepaid
December 31, 2011 NO ENTRY
January 2, 2012 Purchases 1,000
Accounts Payable 1,000
January 5, 2012 Accounts Payable 1,000
Cash 1,000
The buyer does not record the P10 freight cost because the seller is the one who is supposed to
pay for the freight. Under FOB destination, the seller owns the goods in transit. Therefore, the
seller bears the cost of transportation.
C. FOB Shipping point, freight prepaid
December 31, 2011 Purchases 1,000
Freight-in 10
Accounts Payable 1,010
January 2, 2012 NO ENTRY
January 5, 2012 Accounts Payable 1,010
Cash 1,010
The buyer records the P10 freight cost as “freight-in” because the buyer is the one who is
supposed to pay for the freight. However, since the seller already paid the freight (i.e., freight
prepaid), the freight-in is recorded as an increase in “accounts payable.” This is because the
buyer shall reimburse the seller for the freight. A “reimbursement payable” account may be used
in lieu of “accounts payable” most especially when the freight cost is material.
D. FOB destination, freight collect
December 31, 2011 NO ENTRY
January 2, 2012 Purchases 1,000
Accounts Payable 1,000
Accounts Payable 10
Cash 10
January 5, 2012 Accounts Payable 990
Cash 990
The buyer does not recognize freight-in for the freight he had paid (i.e., Freight collect)
because the seller is the one who is supposed to pay for the shipping cost (i.e., FOB
destination). Accordingly, the buyer treats the freight cost as a reduction to the amount that will
be remitted to the seller. The freight does not affect the cost of inventory.
Notice that the accounting for accounting for goods in transit by the buyer is exactly the
same as that of the seller. See discussion in Chapter 4.

Consigned Goods
A consignment involves a consignor transferring goods to a consignee who acts as agent of
the consignor in selling the goods.
Consignor - the owner who transfers the physical possession of certain goods to an agent
called consignee.
Consignee - an agent who sells the goods on behalf of the consignor
Consigned goods are included in consignor's inventory and are excluded from the
consignee's inventory.

Illustration:
ABC Co. provided you the following information for the purposes of determining the amount of
its inventory as of December 31, 2011:
Goods located at the warehouse (Physical Count) 3,800,000
Goods located at the sales department 13,600,000
Goods in-transit purchased FOB Destination 1,600,000
Goods in-transit purchased FOB Shipping point 2,100,000
Freight incurred under “freight prepaid” for the
goods purchased under FOB Shipping point 60,000
Goods held on consignment from XYZ, Inc. 1,800,000

How much is the total inventory on December 31, 2011?

Answer:
Goods located at the warehouse (Physical Count) 3,800,000
Goods located at the sales department 13,600,000
Goods in-transit purchased FOB Shipping point 2,100,000
Freight incurred under “freight prepaid” for the
goods purchased under FOB Shipping point 60,000
Total Inventory on December 31, 2011 19,560,000
Notes:
A. ABC Co. owns the goods in transit purchased under FOB shipping point. Thus the cost
of the goods is included in both inventory and accounts payable.
B. The goods marked “Hold for shipping instructions” are not yet shipped to the buyer as of
December 31,2011, i.e., they were shipped only on January 3,2012. Therefore, ABC Co.
still owns the inventory. No adjustment is made to accounts payable because the
transaction relates to a sale transaction and not a purchase transaction.
C. The goods are properly included in inventory because shipment is not yet made as of
December 31, 2011. The goods were shipped only on January 4, 2012
D. ABC Co. does not own the goods in transit purchased under FOB destination. Thus,
they must be excluded from both inventory and accounts payable.

Inventory Financing Agreements

Product financing agreement - a seller sells inventory to a buyer but assumes an obligation
to repurchase it at a later date.
Pledge of inventory - a borrower uses its inventory as collateral security for a loan.
Loan of inventory - an entity borrows inventory from another entity to be replaced with the
same kind of inventory.

Sale with unusual right of return

The buyer normally recognizes goods purchased under a sale with right of return at the time
of sale, unless the goods purchased does not qualify for recognition as asset. For example,
the buyer does not recognize any inventory when:
a. the buyer assesses that no economic benefits will be derived from the goods, such as when
they are defective or unsalable or;
b. the buyer intends to return the goods to the seller within the time limit allowed under the
sale agreement.

Sale on trial (sale on approval)

A seller allows a prospective customer
to use a good for a given period of
time. At the end of that time, if the
prospective customer is satisfied with
the good, he purchases it. If not, he
returns it to the seller.
 Inventory: Seller, not passed to the
prospective customer until he
approves it and purchases it.
 Physical possession: Buyer
In some cases, the good is
considered sold if it is not returned
within a reasonable period of time
after the trial period has lapsed.
Installment sale
A financing arrangement in which the seller allows the buyer to make payments over an
extended period of time. In an installment sale, the buyer receives the goods at the beginning
of the installment period and makes payments over an installment period. Revenue and
expense are recognized at the time of cash collection and not at the time of sale.
 Inventory: Seller
 Physical possession: Buyer

Bill and hold arrangement

A type of sales arrangement that enables payment ahead of the delivery of the item. It
constitutes a sales arrangement in which a seller of a product bills a customer for the product
upfront but does not ship the product until a later date.
 Inventory: Buyer (upon billing)
 Physical possession: Seller
Provided:
✓ the reason for the bill-and-hold arrangement is substantive;
✓ goods are available for immediate transfer to the customer; and
✓ the seller cannot use the goods or sell them to another customer.

Lay Away Sale

A way of buying something in which a buyer makes a down payment on an item, which the
seller then holds for them while they pay the remainder of the price in installments, after which
they take possession of it. A layaway plan ensures that the buyer will get their chosen
merchandise when they've fully paid for it.
 Inventory: Seller (until the goods are delivered to the buyer)
 Physical possession: Seller
Similar to installment sale. The only difference is that physical possession of goods is not
transferred to the buyer until the final payment.

Illustration:
The records of Aether Co. show the following:

Goods sold on an installment basis to Venti Co., title to the goods is retained is
₱
retained by Aether Co. until full payment is made. Paimon Co. took possession of
880,000
the goods.

Goods sold to Zhongli Co., for which Aether Co. has signed an agreement to
760,000
repurchase the goods sold at a set price that covers all costs related to the inventory.

Goods sold where large returns are predictable. 320,000

Goods received from Raiden Co. for which an agreement was signed requiring
680,000
Aether Co. to replace such goods in the near future.
Purchased goods from Ayaka Co. Billing was received although delivery was
delayed per request of Aether Co. The goods purchased were segregated and ready 20,000
for delivery on demand.

Purchased goods from Keqing Co. on a lay away sale agreement. Aether Co. made
25,000
total payments of ₱ 10,000 during the year.

How much is included as part of Aether Co.’s inventory?

Goods sold to Zhongli Co., for which Aether Co. has signed an agreement to
₱
repurchase the goods sold at a set price that covers all costs related to the
760,000
inventory.

Goods received from Raiden Co. for which an agreement was signed requiring
680,000
Aether Co. to replace such goods in the near future.

Purchased goods from Ayaka Co. Billing was received although delivery was
delayed per request of Aether Co. The goods purchased were segregated and 20,000
ready for delivery on demand.

Answer: 1,460,000

Financial Statement Presentation

All the items that meet the definition of inventory are presented on financial position as one line
item under the caption “Inventories” which are classified as current assets. The breakdown (i.e.,
finished goods, work-in-process, and raw materials and manufacturing supplies) is disclosed in
the notes.

Exercise:
YES/NO: YES if the items are included in your inventory and NO if not.
__1. Items specifically segregated per sale in contract.
__2. Items in receiving department, returned by customer in good condition.
__3. Items shipped today, invoice mailed, FOB shipping point.
__4. Items being used for window display.
__5. Items on counter for sale.
__6. Goods in process.
__7. Goods in the hands of consignees.
__8. Finished goods in transit to customer, FOB destination.
__9. Office supplies.
__10. Defective materials returned to supplier.
Accounting for Inventories
The major objectives of inventory accounting are:
1. Proper determination of periodic income through the recognition of appropriate costs
which are matched with revenue.
2. Proper representation of inventories recognized as assets in financial statements

Inventories are accounted for either through:

a) Perpetual Inventory System
b) Periodic Inventory System
Perpetual Inventory System
➢ The Inventory account is updated each time a purchase or sale is made.
➢ Records called Stock cards are maintained under this system, from which the quantity
and balanced of inventory can be determined at any point of time without the need of
physical count of the inventories.
➢ Perpetual inventory system is commonly used for inventories that are specifically
identifiable and are relatively high valued, such as cars, machineries, heavy equipment
and etc.
Periodic Inventory System
➢ The Inventory account is updated only when physical count is performed.
➢ Under this system the physical count of quantity of goods on hand must be performed
periodically (daily, weekly, monthly or annual basis)
➢ Periodic Inventory System commonly used for inventories that are normally
interchangeable, relatively low valued, and has fast turn over rate such as grocery items,
medicines, electrical parts and office supplies.

Periodic Inventory System Perpetual Inventory System

1. Purchasing of goods amounting to 10,000 on account

Purchases 10,000 Inventory 10,000

Accounts Payable 10,000 Accounts Payable 10,000

2. You paid shipping cost of 1,000 on the purchase above

Freight-in 1,000 Inventory 1,000

Cash 1,000 Cash 1,000

3. You returned damaged goods worth 2,000 to the supplier

Accounts Payable 2,000 Accounts Payable 2,000

Purchase Returns 2,000 Inventory 2,000
 4. You sold goods costing 5,000 for 20,000 on account

Accounts Receivable 20,000 Accounts Receivable 20,000

Sales 20,000 Sales 20,000

No Entry Cost of goods Sold 5,000

Inventory 5,000

5. A customer returned goods with sale price of 800 and cost of 200

Sales Returns 800 Sales Returns 800

Accounts Receivable 800 Accounts Receivable 800

No Entry Inventory 200

Cost of goods sold 200

Variation: Shortage or Overage

There is inventory shortage and overage when an entity uses a perpetual inventory
system and there is a difference between the perpetual inventory balance and the physical
inventory count.
Assume that in the records shows an ending balance of 4,200 but when the company
conducted physical count revealed a balance of 4,000. The inventory shortage is determined as
follows;
Balance per count 4,000
Balance per records 4,200
Difference – shortage (200)

The adjusting under perpetual system a follows

Loss on inventory shortage 200
Inventory 200

Inventory shortage is charged to cost of goods sold if it is considered as normal spoilage

(shrinkage and breakage within a tolerable limit set by management). If considered abnormal
spoilage, the shortage is charged as loss (theft, pilferage, and loss on casualty).

Note that an entity using the periodic inventory system does not report the account Inventory
shortage or overage. The reason is that the periodic method does not have accounting against
which to compare the physical count.
 Perpetual System Periodic System
All increase and decrease in inventory are Increase or decrease in inventory are
recorded on inventory account recorded in the purchases, freight-in
purchase return and purchase discount
accounts as appropriate
Cost of goods sold is debited when inventory Cost of goods sold is not recorded
is sold of and credited for sales return
Physical count is performed only to check the Physical count is necessary to determine the
accuracy of the ledger. balances of inventory on hand and cost of
goods sold.
Computing cost of goods sold is not Requires the use of computation to determine
necessary because the information is already the amount of cost of goods sold.
on the ledger

Under the periodic system, cost of goods sold is a residual amount. Thus, it is affected by
errors in ending inventory and net purchases. When cost of goods sold is misstated, so is the
profit for the period.

Illustration:
Assume that the ending inventory is understated by 5,000.

Should be Erroneous
Inventory, beg. 10,000 10,000
Net purchases 100,000 100,000
Total goods avail for sale 100,000 110,000
Inventory, end (20,000) (15,000) Understated by 5,000
Cost of goods sold 90,000 95,000 Overstated by 5,000

Net Sales 220,000 220,000

Cost of goods sold (90,000) (95,000)
Gross Profit 130,000 125,000 Understated by 5,000

Exercise:
Kazuha Company’s December 31, 2020 year end financial contained the following error:
A. Goods costing P3,000 that Kazuha was holding as a consignee were included in the
physical count on December 31
B. An invoice for goods costing P4,600 was received and entered as a credit purchase on
December 29. The goods arrived on January 2. The supplier the goods FOB destination
on December 27.
C. Goods costing P800 and housed in a special room were inadvertently overlooked when
the physical count was taken.
For each independent error, indicate whether the account is U=understated, O= overstated,
NE=No Effect

A B C
2020 2021 2020 2021 2020 2021
Inventory, beg
Purchases
Inventory, end
Net Income
Retained Earnings, beg
Retained Earnings, end

Measurement
Inventories are measured at LOWER of Cost and Net Realizable Value (LCNRV)
COST
The cost of inventory comprises the following:
1. Purchase Cost
Includes purchase price (net of trade discounts and other rebates), import duties, non-
refundable or non-recoverable purchase taxes, and transport, handling and other costs
directly attributable to the acquisition of inventory.

NOTE: If a person or an entity is a VAT payer, VAT paid are not included in cost of inventory
but rather recognized as ‘Input VAT’

Two types of Discounts

TRADE DISCOUNT CASH DISCOUNT

- To encourage orders in large - To encourage prompt payment
quantities - Deducted from invoice price to
- Deducted from the list price to determine the net payment required
determine the invoice price within the discount period
- Not recorded in books e.g., 2/10, n/30 (2% discount if paid in within 10
e.g., credit terms of 20%, 10% days, and 30 days credit period to settle
account)
Accounting for Cash Discount
a. Gross method- Record discount when only taken; more commonly used because of
cost-benefit consideration and convenience.
b. Net Method- Initially recorded regardless of whether discount is taken or not.
Theoretically [more] correct, as it supports concept of conservatism, historical cost,
and matching.
Illustration:
An entity purchases inventory with a list price of P10,000 on account under credit terms of 20%,
10%, 2/10, n/30.

Gross Method
1. Purchase of Inventory
Purchases 7200
Accounts Payable 7200
(10000 x 80% x 90%)
2. Assume payment is made within the discount period
Accounts Payable 7200
Purchase Discount 144
Cash 7056
3. Assume payment is made beyond the discount period
Accounts Payable 7056
Cash 7056

Net Method
1. Purchase of Inventory
Purchases 7056
Accounts Payable 7056
(10000 x 80% x 90% x 98%)
2. Assume payment is made within the discount period
Accounts Payable 7056
Cash 7056
3. Assume payment is made beyond the discount period
Accounts Payable 7056
Purchase Discount Lost 144
Cash 7200

Illustration:
Dean Sportswear regularly buys sweaters from Mil Company and is allowed trade discounts of
20% and 10% from the list price.

Dean made a purchase during the year and received an invoice with a list price of P600,000, a
freight charge of P15,000 and payment terms of 2/10, n30.

What is the cost of the purchase?

Answer:

List Price P600,000

Trade Discount (20%*600,000) (120,000)
Balance 480,000
T.D (10%*480,000) (48,000)
Invoice Price 432,000 Gross method
Freight Charge 15,000
COST of the PURCHASE P447,000
Net method
Cash Discount (2%*447,000) ( 8,940)
Cost of the Purchase (N.M) P438,060

2. Conversion Cost
Cost necessary in converting raw materials into finished goods. Includes direct labor and
production overhead costs.
Allocation of Production Overhead Costs
a. Fixed Production Overhead
constant regardless of the volume of production
allocated based on NORMAL CAPACITY (expected to achieved on an average period)
e.g., depreciation of factory building and/or equipment
b. Variable Production Overhead
Varies directly with the volume of production
Allocated based on the ACTUAL USE
e.g., indirect labor and indirect materials

3. Other Cost
Necessary in bringing the inventories to their present location and condition.
e.g., Service Providers
Exclusion:
a. Abnormal amount of wasted materials, labor and production costs
b. Storage costs, unless necessary in the production process
c. Administrative overheads that do not contribute to bringing inventories in their present
location and condition
d. Selling costs, e.g., advertising and promotion costs
Exercise:
Brilliant Company has incurred the following costs during the current year:

Cost of purchases based on vendor’s invoices P 5,000,000

Trade discounts already deducted from invoice 500,000
Import Duties 400,000
Freight and Insurance on purchases 1,000,000
Other handling costs relating to imports 100,000
Salaries of Accounting department 600,000
Brokerage commission paid to agents for arranging imports 200,000
Sales Commission paid to sales agents 300,000
After-sales warranty costs 250,000

Inventory Cost Flow

1. First-In, First Out (FIFO)
2. Weighted Average
3. Specific Identification

First-In, First-Out
▪ ‘the goods first purchased are first sold’
▪ Cost of sales - costs from earlier purchases
▪ Income Statement
▪ cost of goods sold is understated
▪ Improper matching of cost against revenue
▪ When there is an inflation, the net income will be higher and if there is a deflation,
the net income will be lower
▪ Ending inventory – costs from the most recent purchases
▪ Statement of Financial Position
▪ inventory is stated in current replacement cost
▪ FIFO – periodic and FIFO – perpetual
▪ Inventory costs are the same
Illustrations:
FIFO – Periodic
Mildred Company is a wholesaler of office supplies. The entity reported the following activity for
inventory of calculators during the month of August:
Units Cost
August 1 Beginning Inventory 20,000 36.00
7 Purchase 30,000 37.20
12 Sale 36,000
21 Purchase 48,000 38.00
22 Sale 38,000
29 Purchase 16,000 38.60
What is the ending inventory on August 31?

Answer:
Beginning Inventory 20,000
16,000 x 38.60 = 617,600
Purchases 30,000
48,000 24,000 x 38.00 = 912,000
16,000 Total Cost 1,529,600
Sales (36,000)
(38,000)
Ending Inventory 40,000 units

FIFO – Perpetual
The following information has been extracted from the records about one product of Jayson
Company:
Purchases Sales Balance
Unit Total Unit Total Unit Total
Date Units Units Units
Cost Cost Cost Cost Cost Cost
Jan 1 8,000 70.00 560,000
6 3,000 70.50 211,500 8,000 70.00 560,000
3,000 70.50 211,500
Feb 5 8,000 70.00 560,000
2,000 70.50 141,000 1,000 70.50 70,500
Mar 5 11,000 73.50 808,500
8 (800) 73.50 (58,800) 1,000 70.50 70,500
10,200 73.50 749,700
Apr 10 1,000 70.50 70,500
6,000 73.50 441,000 4,200 73.50 308,700
30 (300) 73.50 (22,050) 4,500 73.50 330,750

What is the cost of the inventory on April 30?

Answer: 330,750

Weighted Average
▪ Cost of sales and Ending inventory is computed using the weighted average cost of
beginning inventory and all purchases during the period
 Weighted Average - Periodic
Cost of beginning inventory xx
Cost of all purchases xx
Total cost of inventory xx

Total units of beginning inventory xx

Total units of purchases xx
Total units of inventory xx

Weighted Average Unit Cost = Total cost ÷ Total units

Weighted Average – Perpetual (Moving Average Method)

o a new weighted average unit cost must be computed after every purchase and
purchase return
Cost of beginning inventory xx
Cost of purchase xx
Cost of purchase return (xx)
Total cost of goods available xx
Total units of beginning inventory xx
Total units of net purchases xx
Total units of goods available xx

Weighted Average Unit Cost = Total cost ÷ Total units

Illustrations:
Weighted Average – Periodic
Lane Company provided the following inventory card during February:
Purchase Units Balance
Price Units Used Units
Jan 10 100 20,000 20,000
31 10,000 10,000
Feb 8 110 30,000 40,000
9 Returns from factory (Jan.10 lot) (1,000) 41,000
28 11,000 30,000

What is the cost of inventory on February 28?

Answer:
Units Unit Cost Total Cost
Jan 10 Purchase 20,000 100 2,000,000
Feb 8 Purchase 30,000 110 3,300,000
50,000 5,300,000
Weighted Average Unit Cost = 5,300,00 / 50,000
= 106
Ending Inventory in units 30,000
Weighted Average Unit Cost x 106
Cost of Inventory 3,180,000

Weighted Average – Perpetual

During the month of January, Metro Company recorded the following information pertaining to
inventory:
Units Unit Cost Total Cost Units on hand
Balance on 1/1 10,000 100 1,000,000 10,000
Purchased on 1/7 6,000 300 1,800,000 16,000
Sold on 1/20 9,000 7,000
Purchased on 1/25 4,000 500 2,000,000 11,000

Under the moving average method, what amount should Metro report as inventory on January
31?

Answer:
Units Unit Cost Total cost
Jan 1 10,000 100 1,000,000
Jan 7 6,000 300 1,800,000
Balance (2,800,000/16,000 = 175) 16,000 175 2,800,000
Jan 20 sale (9,000) 175 (1,575,000)
Balance 7,000 175 1,225,000
Jan 25 4,000 500 2,000,000
Balance (3,225,000/11,000 = 293) 11,000 293 3,225,000

Specific Identification
▪ Appropriate for inventories segregated for specific project and inventories that are not
ordinarily interchangeable
▪ Not appropriate for inventories with large number of items that are ordinarily
interchangeable
▪ Specific costs are attributed to identified items of inventory
▪ Inventory cost corresponds with the actual physical flow of goods
▪ Very costly to implement even with high-speed computers
Illustration:
Purchases Sales Balance
Unit Total Unit Total
Units Units Total cost
Date Cost Cost Cost Cost
Aug 1 10 500,000 5,000,000 5,000,000
3 7 900,000 6,300,000 11,300,000
14 2 500,000 1,000,000
4 900,000 3,600,000 6,700,000

Relative Sales Price Method

▪ Used when different commodities are purchased at a lump sum
▪ Single cost is apportioned among the commodities based on their respective sales price

Illustration:
During the current year, Link Development Company purchased a tract of land for P9,000,000.
Additional cost of P1,500,000 was incurred in subdividing the land during the year.
Of the tract acreage, 70% was subdivided into residential lots and 30% was conveyed to the city
for road and a park.
Lot Class Number of Lots Sales price per lot
A 100 120,000
B 100 80,000
C 200 50,000

Under the relative sales value method, what is the cost allocated to each Class A lot?
Answer:
Sales Price Fraction Allocated Cost
A (100 x 120,000) 12,000,000 12/30 4,200,000
B (100 x 80,000) 8,000,000 8/30 2,800,000
C (200 x 50,000) 10,000,000 10/30 3,500,000
30,000,000 10,500,000

Cost of Class A per lot (4,200,000 / 100 lots) 42,000

Exercise:
Magdalena Company is a wholesaler of perfume. The activity for product Lomon during June is
presented below:
 Date Transaction Units Selling Price Unit Cost
1 Beginning Inventory 240 1,075
4 Purchases 190 1,135
12 Sales 220 1,200
19 Purchases 380 1,180
22 Sales 360 1,250
27 Purchases 200 1,200

a. Under FIFO method, how much is the ending inventory of product Lomon at June 30?
b. How much is the cost of goods sold under Weighted Average method?
c. How much is the gross profit under Moving Average method?

Lower of Cost and Net Realizable Value

After the initial recognition, inventories are measured at?

a. Fair value
b. Lower of cost and net realizable value
c. Depreciable amount
d. Carrying amount

Answer: B. Lower of cost and net realizable value

What is net realizable value?

Net realizable value or NRV is the estimated selling price in the ordinary course of
business less the estimated cost of completion and estimated cost of disposal. NRV is the net
amount that an entity expects to realize from the sale of inventory in the ordinary course of
business.

In short NRV is equals to …

Selling price – cost of completion – cost of disposal
NRV = net benefit

➢ Writing down inventories from cost to net realizable value is consistent with the basic
accounting concept that “assets shall not be carried in excess of amounts expected to be
realized from their sale or use.”

The cost of inventories may not be recoverable when:

✓ Inventories are damaged.

✓ Inventories have become wholly or partially obsolete.
✓ Selling prices have declined.
✓ Estimated cost of completion or estimated cost of disposal has increased.

Determination of net realizable value

✓ Inventories are usually written down to NRV on item by item or individual basis.
✓ It is not appropriate to write down based on classification of inventory.
✓ Materials and supplies used in production are not written down below cost if finished goods
they are incorporated are expected to be sold at or above cost.

Accounting for inventory write-down

✓ If the cost of an inventory exceeds NRV, the inventory is written down to NRV, the lower
amount. The excess of cost over NRV represents amount of write-down.
✓ If cost of an inventory is lower than net realizable value, there is no accounting problem,
no write-down is necessary.

Direct method or cost of goods sold method

• Inventory is recorded at lower of cost or net realizable value.
• Any loss on inventory write-down is not accounted for separately but buried in the cost of
goods sold.

Allowance method or loss method

• Inventory is recorded at cost.
• Any loss is recorded with debit to loss account and credited to valuation account.

Application of two methods

Materials: Total cost NRV LCNRV
No.1 11,000 10,000 10,000
No.2 69,000 75,000 69,000
No.3 60,000 64,000 60,000
TOTAL 140,000 149,000 139,000

Direct method
Inventory is recorded at lower of cost and NRV.
Inventory 139,000
Income Summary 139,000

✓ The loss on inventory write-down of 1,000 is not accounted for separately. The entry will have
effect of increasing COGS because the NRV is lower than cost.

Allowance method
Inventory is recorded at cost.
Inventory 140,000
Income Summary 140,000
Loss on inventory write-down 1,000
Allowance for inventory write-down 1,000

✓ The loss on inventory write-down of 1,000 is included in the computation of COGS.

✓ The allowance for inventory write-down is presented as deduction from the inventory.
Reversal of Write-down

• If the required allowance increases, additional loss is recognized.

• If the required allowance decreases, a gain on reversal of inventory write-down is recorded

but limited only to the extent of the allowance balance.

Continuing illustration
Assume at year end, total cost of inventory is 160,000 and the NRV is 159,500.

Direct method
Inventory is recorded at lower of cost and NRV
Inventory 159,500
Income Summary 159,500

Allowance Method
Cost 160,000
NRV 159,500
Required allowance 500
Less: Allowance balance 1,000
Decrease in allowance -500

Allowance for inventory write-down 500

Gain on reversal of inventory write-down 500

Problem 1
Cost NRV
Skies 2,200,000 2,500,000
Boots 1,700,000 1,500,000
Ski equipment 700,000 800,000
Ski apparel 400,000 500,000

What amount should be reported as inventory at year-end?

a. 5,000,000
b. 5,300,000
c. 4,800,000
d. 5,200,000
Problem 2
REA Company provided the following information for an inventory at year-end:
Historical cost 1,200,000
Estimated selling price 1,300,000
Estimated completion and selling cost 150,000
Replacement cost 1,100,000

What amount should be reported as inventory at year-end?

a. 1,100,000
b. 1,150,000
c. 1,200,000
d. 1,300,000

Problem 3

AND Company provided the following information for the current year:
Inventory - January 1
Cost 3,000,000
NRV 2,800,000
Net purchases 8,000,000
Inventory - December 31
Cost 4,000,000
NRV 3,700,000

What amount should be reported as cost of goods sold?

a. 7,000,000
b. 7,100,000
c. 7,300,000
d. 7,200,000

GROSS PROFIT METHOD

Definition
The gross profit method estimates the value of inventory by applying the company's historical
gross profit percentage to current‐period information about net sales and the cost of goods
available for sale. Gross profit equals net sales minus the cost of goods sold.

Gross Profit Rate (GPR)

The GPR can be calculated in two ways:
a. Based on Sales
Assume that the gross profit rate based on cost is 20%. Determine the GPR based on
sales.
Net Sales (squeezed) 120%
Cost of Goods Sold (constant) (100%)
Gross Profit Rate based on cost (given) 20%
Using the data on the table, we will divide the gross profit rate by the net sales squeezed.
20%
𝐺𝑃𝑅 𝐵𝐴𝑆𝐸𝐷 𝑂𝑁 𝑆𝐴𝐿𝐸𝑆 =
120%
𝑮𝑷𝑹 𝑩𝑨𝑺𝑬𝑫 𝑶𝑵 𝑺𝑨𝑳𝑬𝑺 = 𝟏𝟔. 𝟔𝟕%

b. Based on Cost of Goods Sold

Assume that the gross profit rate based on sales is 25%. Determine the GPR based on
the cost of goods sold.
Net Sales (constant) 100%
Cost of Goods Sold (squeezed) (75%)
Gross Profit Rate based on cost (given) 25%
Using the data on the table, we will divide the gross profit rate by the cost of goods sold
squeezed.
25%
𝐺𝑃𝑅 𝐵𝐴𝑆𝐸𝐷 𝑂𝑁 𝑆𝐴𝐿𝐸𝑆 =
75%
𝑮𝑷𝑹 𝑩𝑨𝑺𝑬𝑫 𝑶𝑵 𝑺𝑨𝑳𝑬𝑺 = 𝟑𝟑. 𝟑𝟑%

Cost Ratio
The cost ratio is the proportion of the cost of goods available to the retail price of those
goods. The Cost Ratio can be calculated in two ways:
a. Cost Ratio from GPR based on sales
𝑪𝒐𝒔𝒕 𝑹𝒂𝒕𝒊𝒐 𝒇𝒓𝒐𝒎 𝑮𝑷𝑹 𝒃𝒂𝒔𝒆𝒅 𝒐𝒏 𝒔𝒂𝒍𝒆𝒔 = 𝟏𝟎𝟎% 𝒏𝒆𝒕 𝒔𝒂𝒍𝒆𝒔 − 𝑮𝑷𝑹 𝒃𝒂𝒔𝒆𝒅 𝒐𝒏 𝒔𝒂𝒍𝒆𝒔

Assume that the GPR based on sales is 15%. Determine the Cost Ratio.
Formula:
𝐶𝑜𝑠𝑡 𝑅𝑎𝑡𝑖𝑜 𝑓𝑟𝑜𝑚 𝐺𝑃𝑅 𝑏𝑎𝑠𝑒𝑑 𝑜𝑛 𝑠𝑎𝑙𝑒𝑠 = 100% 𝑛𝑒𝑡 𝑠𝑎𝑙𝑒𝑠 − 𝐺𝑃𝑅 𝑏𝑎𝑠𝑒𝑑 𝑜𝑛 𝑠𝑎𝑙𝑒𝑠
𝐶𝑜𝑠𝑡 𝑅𝑎𝑡𝑖𝑜 𝑓𝑟𝑜𝑚 𝐺𝑃𝑅 𝑏𝑎𝑠𝑒𝑑 𝑜𝑛 𝑠𝑎𝑙𝑒𝑠 = 100% − 15%
𝑪𝒐𝒔𝒕 𝑹𝒂𝒕𝒊𝒐 𝒇𝒓𝒐𝒎 𝑮𝑷𝑹 𝒃𝒂𝒔𝒆𝒅 𝒐𝒏 𝒔𝒂𝒍𝒆𝒔 = 𝟖𝟓%

b. Cost Ratio from GPR based on the cost of goods sold

𝑪𝒐𝒔𝒕 𝑹𝒂𝒕𝒊𝒐 𝒇𝒓𝒐𝒎 𝒄𝒐𝒔𝒕 𝒐𝒇 𝒈𝒐𝒐𝒅𝒔 𝒔𝒐𝒍𝒅
𝟏𝟎𝟎% 𝑪𝒐𝒔𝒕 𝒐𝒇 𝑮𝒐𝒐𝒅𝒔 𝑺𝒐𝒍𝒅
=
(𝟏𝟎𝟎% + 𝑮𝑷𝑹 𝒃𝒂𝒔𝒆𝒅 𝒐𝒏 𝒄𝒐𝒔𝒕 𝒐𝒇 𝒈𝒐𝒐𝒅𝒔 𝒔𝒐𝒍𝒅)

Assume that the GPR based on the cost of goods sold is 25%. Determine the Cost
Ratio.
Formula:
 100%
𝐶𝑜𝑠𝑡 𝑅𝑎𝑡𝑖𝑜 𝑓𝑟𝑜𝑚 𝑐𝑜𝑠𝑡 𝑜𝑓 𝑔𝑜𝑜𝑑𝑠 𝑠𝑜𝑙𝑑 =
(100% + 25%)
100%
𝐶𝑜𝑠𝑡 𝑅𝑎𝑡𝑖𝑜 𝑓𝑟𝑜𝑚 𝑐𝑜𝑠𝑡 𝑜𝑓 𝑔𝑜𝑜𝑑𝑠 𝑠𝑜𝑙𝑑 =
(125%)
𝑪𝒐𝒔𝒕 𝑹𝒂𝒕𝒊𝒐 𝒇𝒓𝒐𝒎 𝒄𝒐𝒔𝒕 𝒐𝒇 𝒈𝒐𝒐𝒅𝒔 𝒔𝒐𝒍𝒅 = 𝟖𝟎%

Note: In determining the Net Sales, it is important to remember that only sales return
is being considered. Sales discounts and sales allowances are not deducted from net
sales because sales discounts and sales allowances do not affect the inventory
physically, and they affect the selling prices.

Before we illustrate the process of using the Gross Profit Method, let’s recall the relationship of
accounts payable and inventory using the T Accounts.
Accounts Payable Inventory
Beg.
Beg. Balance Balance
Payments Net
to Purchases
suppliers Net Purchases Freight in COGS
End. End.
Balance Balance

Purchasing inventory on credit is one of the most common sources of accounts payable.
Expenses that aren't paid right away are a second source of accounts payable. As a result, the
total sum of the company's accounts payable liability is divided into two pieces, one for each
source.

Formula derived from T Accounts:

Inventory, Beginning balance xx
Net Purchases xx
Freight in xx
Total Goods Available for Sale xx
Inventory, Ending balance (xx)
Cost of Goods Sold xx

Illustration: Gross Profit based on Sales

On January 1, 2022, a fire destroyed the warehouse of Afton Company including the inventories
inside. Afton Company reported the following data for the year 2021:
Inventory, Jan 1 40,000
Accounts Payable, Jan 1 5,000
Accounts Payable, Dec 31 3,000
Payments to Suppliers 35,000
Freight in 4,500
 Sales 90,000
Sales return 7,500
Sales discount 3,000
Gross Profit Rate based on sales 20%

Goods in Transit on December 31 amounted to 3,000 while goods out on consignment were
2,000. Damaged materials can be sold at a salvage value of 800.
Compute the loss due to the fire.

Net Purchases solution:

Accounts Payable
5,000

35,000 33,000 (Net Purchases)

3,000

Cost of Goods Sold Solution:

Gross Sales 90,000
Sales Return (7,500)
Net Sales 82,500
Multiply by: Cost Ratio (100% - 20%) 80%
Cost of Goods Sold 66,000

Ending Inventory Solution:

Inventory
40,000
33,000
4,500 66,000
11,500 (Ending Balance)

Loss is computed as follows:

Ending Balance of Inventory 11,500
Goods in Transit (3,000)
Goods out of Consignment (2,000)
Salvage Value (800)
Inventory Loss due to the fire 5,700
Exercise:
I. On January 1, 2022, a fire destroyed the warehouse of Afton Company including the inventories
inside. Afton Company reported the following data for the year 2021:
Inventory, Jan 1 50,000
Accounts Payable, Jan 1 5,000
Accounts Payable, Dec 31 3,000
Payments to Suppliers 30,000
Freight in 3,500
Sales 75,000
Sales return 5,500
Sales discount 2,000
Gross Profit Rate based on the cost of goods 20%
sold
Goods in Transit on December 31 amounted to 3,000 while goods out on consignment were
2,000. Damaged materials can be sold at a salvage value of 800.
1. Determine the Total Net Purchases.
2. What is the total Ending Inventory?
3. Compute the total loss due to fire.

Retail Inventory Method

Records needed for retail inventory method
A. Beginning inventory at cost and at retail price
B. Purchases during the period at cost and at retail price
C. Adjustments to the original retail price
a. Additional mark up
b. Markup cancellation
c. Markdown
d. Markdown cancellation
D. Other adjustments
a. Departmental transfer
b. Breakage
c. Theft
d. Damaged goods
e. Employee discount

Basic formulas
Goods available for sale at retail or selling price xx
Less: Net sales (Gross sales minus sales return only) (xx)
Ending Inventory at selling price xx
Multiply: Cost ratio xx
Ending Inventory at cost xx
 Cost Retail
Beginning Inventory xx xx
Purchases xx xx
Freight in xx
Purchase returns (xx) (xx)
Purchase allowances (xx)
Departmental transfer in / debit xx xx
Departmental transfer out / credit (xx) (xx)
Markup xx
Markup cancelation (xx)
Markdown (xx)
Markdown cancelation xx
Abnormal shortage (xx)
Goods available for sale xx xx

Sales xx
Sales return (xx)
Employee discount xx
Normal losses (xx)
Net sales xx

Goods available for sale at cost

Cost ratio =
Goods available for sale at selling price

Items related to retail method

➢ Initial markup – original markup on the cost of goods
➢ Original retail – sales price at which goods are first offered for sale
➢ Additional markup – increase in sales price above original sales price
➢ Markup cancelation – decrease in sales price that does not decrease in sales price below
original retail.
➢ Net markup – markup minus markup cancelation
➢ Markdown - decrease in sales price below original sales price.
➢ Markup cancelation – increase in sales price that does not increase in sales price above
original retail.
➢ Net markdown – markdown minus markdown cancelation
➢ Maintained markdown – difference between cost and sales price after adjustments of all above
items.
Approaches in the use of retail method
➢ Conservative or conventional or lower of cost and net realizable value approach -
includes net markup and excludes net markdown in determining cost ratio in order to arrive a
conservative cost.
➢ Average cost approach – includes both net markup and net markdown in determining cost
ratio.
➢ FIFO approach – similar to average cost approach in that it considers both net markup and
net markdown in computing cost ratio, however current cost ratio is determined by excluding
the beginning inventory.

Sample: Conservative Approach

Cost Retail
Beginning Inventory 8,700 14,000
Purchases 55,300 80,300
Freight in 2,000
Purchase returns 5,200 8,600
Purchase discount 500
Departmental transfer in / debit 1000 1,500
Departmental transfer out / credit 800 1,200
Markup 6,000
Markup cancelation 2,000
Markdown 12,000
Markdown cancelation 3,000
Abnormal shortage 5,000 7,000
Goods available for sale xx xx

Cost Retail
Beginning Inventory 8,700 14,000
Purchases 55,300 80,300
Freight in 2,000
Purchase returns (5,200) (8,600)
Purchase discount (500)
Departmental transfer in / debit 1000 1,500
Departmental transfer out / credit (800) (1,200)
Markup 6,000
Markup cancelation (2,000)
Abnormal shortage (5,000) (7,000)
Goods available for sale 55,500 83,000
 Goods available for sale at cost
Cost ratio =
Goods available for sale at selling price

55,500
73% =
83,000

Sample: Average Approach

Cost Retail
Beginning Inventory 8,700 14,000
Purchases 55,300 80,300
Freight in 2,000
Purchase returns 5,200 8,600
Purchase discount 500
Departmental transfer in / debit 1000 1,500
Departmental transfer out / credit 800 1,200
Markup 6,000
Markup cancelation 2,000
Markdown 12,000
Markdown cancelation 3,000
Abnormal shortage 5,000 7,000
Goods available for sale xx xx

Cost Retail
Beginning Inventory 8,700 14,000
Purchases 55,300 80,300
Freight in 2,000
Purchase returns (5,200) (8,600)
Purchase discount (500)
Departmental transfer in / debit 1000 1,500
Departmental transfer out / credit (800) (1,200)
Markup 6,000
Markup cancelation (2,000)
Markdown (12,000)
Markdown cancelation 3,000
Abnormal shortage (5,000) (7,000)
Goods available for sale 55,500 74,000
 Goods available for sale at cost
Cost ratio =
Goods available for sale at selling price

55,500
75% =
74,000

Sample: FIFO Approach

Cost Retail
Beginning Inventory 8,700 14,000
Purchases 55,300 80,300
Freight in 2,000
Purchase returns 5,200 8,600
Purchase allowances 500
Departmental transfer in / debit 1000 1,500
Departmental transfer out / credit 800 1,200
Markup 6,000
Markup cancelation 2,000
Markdown 12,000
Markdown cancelation 3,000
Abnormal shortage 5,000 7,000
Goods available for sale xx xx

Cost Retail
Beginning Inventory 8,700 14,000
Purchases 55,300 80,300
Freight in 2,000
Purchase returns (5,200) (8,600)
Purchase allowances (500)
Departmental transfer in / debit 1000 1,500
Departmental transfer out / credit (800) (1,200)
Markup 6,000
Markup cancelation (2,000)
Markdown (12,000)
Markdown cancelation 3,000
Abnormal shortage (5,000) (7,000)
Goods available for sale 55,500 74,000
 TGAS at cost– Beg. Inventory
Cost ratio =
TGAS @ retail – Beg. Inventory

46,800
78% =
60,000

Conservative Average FIFO

Goods available for sale at retail or
selling price 74,000 74,000 74,000
Net sales (Gross sales minus sales
return only) (42,000) (42,000) (42,000)

Ending Inventory at selling price 32,000 32,000 32,000

Multiply: Cost ratio 73% 75% 78%

Ending Inventory at cost 23,360 24,000 24,960

TGAS @ cost 55,500 55,500 55,500

Ending inventory (23,360) (24,000) (24,960)

COGS 32,140 31,500 30,540

Problem 1
Kim Company used the retail method to estimate inventory at year end.
Cost Retail

Beginning inventory 720,000 1,000,000

Purchases 4,080,000 6,300,000

Net Markup 700,000

Net Markdown 500,000

Sales 6,820,000

Estimated normal shoplifiting losses 80,000

What amount should be reported as inventory at year-end?
a. 408,000
b. 600,000
c. 360,000
d. 384,000

Problem 2
Jin Company used the average cost retail method to estimate inventory at year end.
Cost Retail
Beginning inventory 6,000,000 9,200,000
Net Markup 400,000
Net Markdown 600,000
Sales 7,800,000

What amount should be reported as cost of goods sold for the current year?
a. 4,800,000
b. 4,875,000
c. 5,200,000
d. 5,250,000