Module 3 – Inventories

Lesson 1: Definition, Measurement and Presentation of Inventories

Inventories (PAS 2) are assets:

 Held for sale in the ordinary course of business (Finished Goods but in merchandising, it is
called merchandised goods). Ex. Car – in Toyota, it is an inventory but for schools, it is not;
 In the process of production for such sale (Work In Process – the process to turn raw
materials to finished goods); or
 In the form of materials or supplies to be consumed in the production process or in the
rendering of services (Raw materials and manufacturing supplies).

Inventories encompass goods purchased and held for resale, for example:

 Merchandise purchased by a retailer and held for resale

Inventories also encompass finished goods produced, goods in process and materials and supplies
awaiting use in the production process.

Classes of Inventories

Inventories are broadly classified into two, namely inventories of a trading concern and
inventories of a manufacturing concern. A trading concern is one that buys and sells goods in the
same form purchased. The term merchandise inventory is generally applied to goods held by a
trading concern.

A manufacturing concern is one that buys goods which are altered or converted into
another form before they are made available for sale. The inventories of a manufacturing concern
are:

 Finished goods
 Goods in process
 Raw materials
 Factory or manufacturing supplies
Measurement of Inventory

Inventories are measured at the lower of cost and net realizable value (NRV) (– what can
be recovered afterwards). The cost of inventories comprise all costs of purchase, costs of
conversion and other costs incurred in bringing the inventories to their present location and
condition. Net realizable value (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.

 Measurement exceptions
o Producers of agricultural, forest products, minerals and mineral products
o Commodity dealers and brokers
 Cost measurement techniques – for convenience to approximated cost of inventories
o Standards costs – producers of large amount of small items
o Retail method – retailers with large turnover of inventories with similar profit
margin

Cost of Inventory

The cost of inventories shall comprise:

1. Cost of purchase - comprises the purchase price, import duties and irrecoverable taxes,
freight, handling and other costs directly attributable to the acquisition of finished goods,
materials and services. Trade discounts, rebates and other similar items are deducted in
determining the cost of purchase.
2. Cost of conversion - includes cost directly related to the units of production such as direct
labor. It also includes a systematic allocation of fixed and variable production overhead that
is incurred in converting materials into finished goods. Fixed production overhead is the
indirect cost of production that remains relatively constant regardless of the volume of
production. Examples are depreciation and maintenance of factory building and equipment,
and the cost of factory management and administration. Variable production overhead is
the indirect cost of production that varies directly with the volume of production. Examples
are indirect labor and indirect materials.
3. Other cost - included only to the extent that it is incurred in bringing the inventories to
their present location and condition. For example, it may be appropriate to include the cost
of designing product for specific customers in the cost of inventories.
Ex. Purchase price = 50,000, shipping fee = 1,000, and insurance = 5,000

The following costs are excluded from the cost of inventories and recognized as expenses in
the period when incurred:

1. Abnormal amounts of wasted materials, labor or other production costs. (ex. Carelessness)
2. Selling costs, for example, advertising and promotion costs and delivery expense or freight
out. (ex. Freight-in – included but freight-out – not included)
3. Administrative overheads that do not contribute to bringing inventories to their present
location and condition.
4. Storage costs, unless those costs are necessary in the production process before a further
production stage. (ex. Storage of raw materials and WIP – included but storage of finished
goods – not included)

Cost of inventories of a service provider

The cost of inventories of a service provider consists primarily of the labor and other costs
of personnel directly engaged in providing the service, including supervisory personnel and
attributable overhead. Labor and other costs relating to sales and general administrative personnel
are not included but are recognized as expenses

Net Realizable Value

Net realizable value (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. The cost
of inventories may not be recoverable under the following circumstances:

1. The inventories are damaged

Inventories are usually written down to net realizable value on an item by item or
individual basis.

Ex.
Date Cost NRV Journal Entry
1/1 (your new 50,000 80,000 Inventory 50,000
product) Cash 50,000
3/1 (other new 50,000 40,000 Impairment Loss 10,000
product) Inventory 10,000
3/31 (other new 50,000 48,000 Inventory 8,000
product is Gain on Reversal 8,000
defective)
4/15 (other new 50,000 70,000 Inventory 2,000
product no Gain on Reversal 2,000
longer sells)
*Note: Depreciation means gradually loss of inventory due to usage while impairment means
immediate loss of inventory due to problems such as obsolete

Presentation of Inventory

All items that meet the definition of inventory are presented on the statement of financial
position as one line item under the caption “Inventories.” The breakdown of this line item (as
finished goods, WIP and Raw materials) is disclosed in the notes. Inventories are normally
presented in a classified statement of financial position as current assets.

Lesson 2: Cost Formulas and Inventory Writedown

Ex. Beg. Balance 10k

Purchases 100k

TGAS (Total Goods Available for Sale) 110k

Will end up either being sold during the year COGS (Cost of Goods Sold) or Ending Inventory

1. FIFO (First in, first out) – cost of sales is based on the cost of inventories that were
purchased first. Consequently, ending inventory represents the cost of the latest purchases.
It assumes that goods first purchased are first sold. In other words, FIFO is in accordance
with the ordinary merchandising procedure that the goods are sold in the order they are
purchased or produced. The objection to the 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 cost of goods sold. Accordingly, in a period of inflation, the FIFO method
would result to the highest net income. In a period of deflation, the FIFO method would
result to the lowest net income.
Ex. Day 1 – 1,000L @ P31 Cost: 1,300 (Day 1 and 2) so
Day 2 – 500L @P30 (1000 x 31) + (300 x 30) = 40k
Day 3 – 2,000L @ P32
2. Weighted Average Cost – cost of sales is based on the average cost of all inventories
purchased during the period. The cost of the beginning inventory plus the total cost of
purchases during the period is divided by the total units purchased plus those in the
beginning inventory to get a weighted average unit cost.
Formula: Wtd. Ave. Cost = (TGAS in Pesos / TGAS in Units)
Ex. Day 1 – 1,000L @ P31 = 31k
Day 2 – 500L @P30 = 15k
Day 3 – 2,000L @ P32 = 64k
Total: 3,500 110k
110k/3,500 = 31,43 liters x 1,300 = 40,859
3. Specific identification - shall be used for inventories that are not ordinarily
interchangeable (i.e., used for inventories that are unique). Cost of sales is the cost of the
specific inventory that was sold.
Ex. Cost of Car A – 500k COGS: 600k
B – 600k (bought) End. Inventory: 1.3m (500k + 800k)
C – 800k *with serial number (unique)
4. LIFO (Last in, first out) - assumes that the goods last purchased are first sold and
consequently the goods remaining in the inventory at the end of the period are those first
purchased or produced. It favors the income statement because there is matching of current
cost against current revenue, the cost goods sold being expressed in terms of current or
recent cost. The objection of the LIFO is that the inventory is slated at earlier or older prices
and therefore they may be a significant lag between inventory valuation and current
replacement cost. Accordingly, in a period of inflation, the LIFO method would result to the
lowest net income. In a period of deflation, the LIFO method would result to the highest net
income.

PAS 2 paragraph 25 expressly provides that the cost of inventories shall be determined
using either FIFO or weighted average method.
Accounting for Inventory Write Down

Inventories are usually written down to net realizable value on an item by item basis. If the
cost of an inventory exceeds its NRV, the inventory is written down to NRV, the lower amount. The
excess of cost over NRV represents the amount of write-down. The write down of inventory to net
realizable value is accounted for using the allowance method.

Allowance Method

The inventory is recorded at cost and any loss on inventory write down is accounted for
separately. A "loss on inventory write down" is debited and a valuation account "allowance for
inventory write down" is credited. In subsequent years, his allowance is adjusted upward or
downward depending on the difference between the cost and net realizable value of the inventory
at year-end. If the required allowance increases, an additional loss is recognized. If the required
allowance decreases, a gain on reversal of inventory write down is recorded. However, the amount
of reversal to be recognized should not exceed the amount of the original write-down previously
recognized.

PAS 2 required disclosure of the amount of any inventory write down and the amount of
any reversal of inventory write down.

Recognition as an expense

The carrying amount of an inventory that is sold is charged as an expense (i.e. cost of sales)
in the period in which the related revenue is recognized. Likewise, the write-down of inventories to
NRV and all losses of inventories are recognized as expense in the period the write-down or loss
occurs.

 Inventory – cost of goods sold – matching principle when sold

Debit Credit
When inventories are sold: Cost of Sales Inventory
Write-down of inventories: Impairment Loss Inventory (allowance)
Reversal of write-down: Inventory (allowance) Gain on reversal of inventory