INVENTORY

NATURE AND DEFINITION

Inventories are assets:

• 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.
OWNERSHIP OF INVENTORIES

Ø When a company has the TITLE to the goods, regardless

of their location, the ownership remains with the
company
Ø The following may require special attention in
determining the proper inventory items at the end of the
period
Ø Inventories in transit
Ø Inventories under consignment
Ø Inventories in the hands of a sales agency
Ø Goods held by the customer for approval or trial
Ø Bill and hold sales
Ø Segregated goods
Ø Installment sales
Ø Goods sold with buyback agreements
Ø Goods sold with refund offers
INVENTORIES IN TRANSIT
Ø IF the goods are in transit, the freight terms to consider in
determining the ownership of the inventories are:
Ø FOB shipping point
Ø FOB destination
Ø Other inventory shipping terms include maritime shipping terms
in which there are three main items under this namely, Free
Along Side (FAS), Cost Insurance and Freight (CIF) and Ex-ship
Ø Free along side
• A seller who ships FAS is responsible for all costs and risks associated with getting goods
to the dock next to or alongside the vessel on which the goods will be shipped
• The expense of loading and shipping is borne by the buyer, and the title passes when the
carrier takes possession
• In other words, it is the same as FOB shipping point
Ø Cost, insurance, and Freight
• The buyer agrees to pay the cost of the products, insurance, and freight in one single
amount under this shipping contract
• The shipping contract can be changed to CF
• In both cases, the seller is responsible for the cost of loading. As a result, title and risk of
loss pass to the buyer when the items are delivered to the carrier
• In other words, same as FOB shipping point
Ø Ex-ship
• Seller is responsible for a cost and risk of loss until the goods are unloaded, at which point
title and risk of loss pass to the buyer
• In other words, it is the same as FOB destination
INVENTORIES ON CONSIGNMENT
Ø Consignment refers to an agreement between two parties
wherein the consignor us contracting with the consignee to
sell goods on its behalf
Ø The ownership of the goods remain with the consignor
Ø Accounts involved in consignment
Ø Goods held on consignment account is ordinarily associated with
the consignee, thus, the amount related to the said account will
not form part of its inventories
Ø Goods out on consignment account is ordinarily associated with
the consignor, thus, the amount related to the said account will
form part of its inventories
INVENTORIES IN THE HANDS OF A
SALES AGENCY
Ø Sales agency pertains to the marketing
arm of an entity. It could be a small team
whose function is to market the products
or services provided by the entity and
any potential sales should be approved
first by the entity before it becomes an
official sale transaction
Ø The entity that owns the sales agency is
also entitled to the ownership of the
inventories held by the said sales agency
 Goods held by customer for
approval or Trial
Ø If the items are provided to a customer
for approval or trial, Ownership remains
with the seller, even if the customer has
the physical possession of them
 Bill- and- hold Sales
Ø A bill and hold arrangement is a contract under
which a seller bills a customer but retains physical
possession of the goods until it is transferred to the
customer at a future date.
Ø The goods are excluded from the seller’s inventory
and included in the buyer’s inventory upon BILLING,
provided:
Ø The reason for the bill and hold arrangement is
substantive (e.g. the customer requested for the
arrangement)
Ø The goods are identified separately as belonging to
the customer
Ø The goods are available for immediate transfer to the
customer; and
Ø The seller cannot use the goods or sell them to
another customer
 SEGREGATED GOODS
Ø Special order goods manufactured according
to customer specifications should be
considered sold when completed, even if it
is still in the possession of the seller.
Therefore, these are excluded from the
seller’s inventory
Ø Goods that are customarily manufactured
and constitute stock items of the entity even
if physically segregated, are still included in
the inventory of the seller until delivered to
the customer
 INSTALLMENT SALES
Ø Goods under installment basis are included
in the inventory of the buyer despite the
retention of the title by the seller until fully
paid. The substance is that control over the
goods has already passed to the buyer at the
time of sale
PROBLEM 1
The Nokia Corp. is on a calendar year basis. The following data were found during your audit:

a. An excerpt from the client’s trial balance revealed the following account balances:
Accounts receivable 680,000
Inventory, per count P1,200,000
Accounts payable 790,000
Net sales 6,050,000
Net Purchases 3,300,000
Net income 610,000
b. The client conducted an inventory count on December 31, 20XX Nokia Corp. normally sells at 30% gross profit based on selling price.
c. Goods were in transit FOB destination from a supplier in the amount of P120,000. Further testing revealed that the suppliers invoice pertaining to
the delivery was received and recorded on December 28, 20XX.
d. Goods costing P70,000 had been received on December 31, and recorded as a purchase. However, upon your inspection the goods were found to be
defective and would be immediately returned.
e. Materials costing P224,000, sold and billed on December 30 under a “bill and hold” agreement, had been segregated in the warehouse awaiting pick-
up by customer. Being on hand, the materials had been included in the count.
f. Goods costing P70,000 was out on consignment with Sony Company. Since the monthly statement from Sony listed those materials as on hand, the
items had been excluded from the final inventory and invoiced on December 31 at a normal Gross Profit provision.
g. The sale of materials invoiced at P150,000 had been shipped FOB point of shipment on December 31. However, this inventory was found to be
included in the final inventory. The sale was properly recorded in 20XX.
h. Goods costing P98,000 had been segregated but not shipped at December 31. A review of the customer’s purchase order related to the goods set
forth terms as FOB Shipping point. The sale had not been recorded while the goods were excluded from the count.
i. Your client has an invoice from a supplier, terms FOB shipping point but the goods had not arrived as yet. While these materials costing P170,000
had been included in the inventory count, no entry had been made for their purchase.
j. Merchandise costing P200,000 had been recorded as a purchase but not included as inventory. Terms of sale are FOB shipping point according to
the supplier’s invoice which had arrived at December 31.

Requirements: Determine the correct balances of the following:

1. Inventory:
2. Accounts payable
3. Net sales
4. Net purchases
5. Net income
 SOLUTION 1
INVENTORY ACCOUNTS NET SALES NET NET
PAYABLE PURCHASES INCOME
Unadjusted Balance 1,200,000 790,000 6,050,000 3,300,000 610,000

Purchase in Transit- FOB (120,000) (120,000) 120,000

Destination

Unrecorded purchase (70,000) (70,000) (70,000)

returns/allowance
“bill and Hold” sales (224,000) (224,000)

Goods on consignment 70,0000 (100,000) (30,000)

Sale in Transit-FOB Shipping Point (105,000) (105,000)

Goods segregated but not yet sold 98,000 98,000

Purchase in transit-FOB shipping 170,000 170,000 (170,000)

point
Purchase in Transit-FOB shipping 200,000 200,000
point
Adjusted Balance 1,169,000 770,000 5,950,000 3,820,000 499,000
PROBLEM 2

You are engaged in an audit of financial statements of Tour Company for the year ended
October 31, 20XX, and have observed the physical inventory count on October 30, 20XX.

All merchandise received up to and including October 30, 20XX has been included in the physical count which totaled to P354,500. As a result of the
count, the following cost of sales schedule has been prepared by the client’s accountant:

Tour Company
Schedule of Cost of Sales
For the period ended October 31, 20XX

Inventory, November 1, 2017 P235,000

Net Purchases, unadjusted 2,543,900
Cost of goods available for sale P2,778,900
Inventory, per count (354,500)
Cost of sales P2,424,400

The following list of invoices is for purchases of merchandise and are entered in the purchase journal for the months of October and November 20XX:

OCTOBER

Receiving Date
Report No. Amount Freight terms Date of Invoice Merchandise
were received
11201 P14,400 Destination October 19 October 21
11202 8,800 Destination October 20 October 22
11203 18,500 Shipping point October 20 October 30
11204 7,800 Destination October 25 November 3
11205 5,000 Destination November 4 October 29
11206 20,500 Shipping point October 25 October 30
11207 18,400 Shipping point October 25 October 30
11208 24,200 Destination October 21 October 30
11209 69,200 Destination October 29 October 30
NOVEMBER

Date
Receiving Amount Freight terms Date of Invoice Merchandise
Report No. were received
11210 P4,000 Destination October 29 October 31
11211 9,700 Destination October 30 October 30
11212 12,840 Shipping point October 27 October 30
11213 14,440 Shipping point November 2 November 3
11214 25,640 Shipping point October 23 November 3
11215 28,400 Shipping point October 23 November 3
11216 14,200 Destination October 27 November 3

Requirements:
1. Adjusting journal entries resulting form the cut-off procedures.

2. The adjusted balance of the Inventory account as of October 31, 20XX.

3. The correct Cost of sales for the period ended October 31, 20XX.
SOLUTION 2

PURCHASES INVENTORY

Unadjusted Balance 2,543,900 354,500

RR #11204 (7,800)

RR #11210 4,000 4,000

RR #11211 9,700

RR #11212 12,840

RR #11214 25,640 25,640

RR #11215 28,400 28,400

Total adjustments 72,780 58,040

Adjusted Balances 2,616,680 412,540

ADJUSTING ENTRY

Debit Credit

Purchases 72,780
Accounts payable 72,780

Inventory 58,040
Income Summary 58,040
Inventory, Nov 1 235,000

Net Purchases, Adjusted 2,616,680

Cost of Goods Available for Sale 2,851,680

Inventory, Oct 31, adjusted (412,540)

COST OF GOODS SOLD 2,439,140

ANSWER

Unadjusted inventory Balance P2,500,000

a. Goods purchased FAS (in transit)
b. Goods purchased CIF (in transit)
c. Goods purchased ex-ship (in transit) (100,000)
d. Goods sold FOB seller (in transit) (200,000)
e. Goods sold Fob buyer (in transit)
adjusted Inventory Balance P2,200,000
 INVENTORY SYSTEM
Periodic System

Also called the physical system

•Does not maintain continuous record of
the physical quantities (or costs) of
inventory on hand
•Physical count is taken at least once a year.
•Uses the account titles: Purchases,
Purchase Discounts, Purchase Returns and
Allowances, and Freight-in.
 INVENTORY SYSTEM
Perpetual System
• Maintains continuous records (detailed subsidiary records) of the
movement of the items in the inventory.
• Uses the account titles Merchandise Inventory and Cost of Goods Sold
• A physical count is made at least once a year to confirm the inventory
balance per books
• Makes use of the account Inventory Over and Short to reconcile the
difference between inventory balance and the physical count.
• The Inventory Over and Short is usually closed to cost of goods sold
because this is often the result of normal shrinkage and breakage in
inventory.
• However, abnormal and material shortage should be separately classified
and presented as other expense.
 INVENTORY SYSTEM
Perpetual System
• Maintains continuous records (detailed subsidiary records) of the
movement of the items in the inventory.
• Uses the account titles Merchandise Inventory and Cost of Goods Sold
• A physical count is made at least once a year to confirm the inventory
balance per books
• Makes use of the account Inventory Over and Short to reconcile the
difference between inventory balance and the physical count.
• The Inventory Over and Short is usually closed to cost of goods sold
because this is often the result of normal shrinkage and breakage in
inventory.
• However, abnormal and material shortage should be separately classified
and presented as other expense.
 INVENTORY COST FLOW
METHODS
Specific identification
• Specific costs are attributed to identified items of
inventory
• Applicable for inventory with a small number and are
easily distinguishable.
• Makes possible to manipulate net income
•
Average cost
• Considers goods to be indistinguishable
• Goods are valued at an average of the costs incurred.
• Weighted average (periodic system) and moving
average (perpetual system).
•
 INVENTORY COST FLOW
METHODS
FIFO (First in First out)
• The first goods purchased are first sold.
• Ending inventory is presumed to consist of the most recent costs.
• There is no proper matching of costs and revenues since old costs
are matched against current revenues.
• Favors the balance sheet because ending inventory approximates
replacement costs.

LIFO (Last in First out) – the new standard prohibits the use of
LIFO inventory costing.
• The last goods purchased are first sold.
• The cost of good sold comes from the most recent purchases.
• Ending inventory is presumed to consist of the earlier costs.
• Favors the income statement because there is proper matching
of costs against revenue.
MEASUREMENT OF INVENTORIES
INITIAL MEASEUREMENT
1. Cost of purchase
• Include purchase price, import duties and taxes, freight, handling and other cost
• Net of trade discounts and rebates.
2. Cost of conversion
• Include cost directly related to the units of production (ex: direct labor, allocation of
fixed and variable production overhead)
• Fixed production overhead – indirect costs of production that remains relatively
constant regardless of the volume of production.
• Variable production overhead – indirect costs of production that vary directly with
the volume of production.
3. Other costs
• Costs incurred in bringing the inventories to their present location and condition.
The following are excluded from the cost of inventories and are recognized as
expenses:
• Abnormal amounts of wasted materials, labor, and other production cost
• Storage costs not unless these are necessary in the production process prior to a further
production stage
• Administrative overheads that do not contribute to bringing inventories to their present
location and condition.
• Selling cost e.g. advertising and promotion costs and deliver expense or freight out
 VALUATION OF INVENTORY
1. Inventories shall be measured at the lower of cost or net realizable
value.
• Net realizable value – 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.
2. The cost of inventories should be determined by using either the FIFO
method or weighted average method. The new standards prohibit the
use of LIFO inventory costing.
3. The cost of inventories that are not ordinarily interchangeable and
inventories that are segregated for specific projects should be
determined by using specific identification method.
 LCNRV
1. Inventories are recorded at their original cost.
2. Inventories decline in value below its cost.
3. Reasons for the decline:
• Obsolescence
• Price level changes
• Damaged goods
4. Inventory should be written down to reflect the loss.
5. Inventories that experience a decline in value shall be measured at lower of cost or net
realizable value.
6. Cost is the acquisition price of inventory.
7. Net Realizable Value (NRV) = Estimated Selling Price - Estimated Cost of
Completion and Disposal
8. Lower of cost or net realizable value is applied on an item by item basis or
individual basis.
LCNRV can be consistently applied to batches of a product using a FIFO or weighted
average cost flow assumptions, or groups of similar products.
9. LCNRV is consistent with the Doctrine of Conservatism
10. Inventories of materials and supplies held for use in the production process are not
written down below cost if the finished goods in which they are expected to be
incorporated are expected to be sold at or above cost.
11. Only when the sale of finished goods is not expected to recover the costs are the
materials and supplies written down to their net realizable value.
ANSWER
a. FIFO
Ending inventory ( 250,000 x P35) P8,750,000
b. WEIGHTED AVERAGE
UNITS UNIT COST TOTAL COST

Beg inventory 100,000 P20 P2,000,000

Purchase-Jan 10 200,000 25 5,000,000

Purchase-Jan 18 300,000 30 9,000,000

Purchase- Jan 28 400,000 35 14,000,000

TGAS 1,000,000 P30 P30,000,000

Ending inventory (250,000 x P30) P7,500,000

ANSWER

DATE Transactio # of units Unit cost Total cost

n
Jan 1 BI 10,000 P100 P1,000,000
Jan 15 purchase 6,000 P300 P1,800,000
16,000 P175 P2,800,000
Jan 20 sale (8,000) 175 1,400,000
8,000 175 1,400,000
jan 25 purchase 3000 500 1,500,000
11,000 263.64 2,900,000
ANSWER
A.
2021
cost P3,200,000
NRV 2,800,000 P400,000
2022
cost P4,000,000
NRV 3,840,000 160,000 P240,000

B.
Beginning inventory P3,200,000

Purchases 16,000,000

Less ending inventory 4,000,000

COGS-unadjusted P15,200,000

Gain on reversal of inventory writedown (240,000)

COGS-adjusted P14,960,000
 INVENTORY ESTIMATION
TECHNIQUES
1. Gross Profit Method or Gross Margin Method
• Gross profit may be expressed as
• a percentage of sales – gross profit / sales
• a percentage of cost of goods sold – gross profit / cost of goods sold

• It is useful in the following instances:

• In determining inventory amount to be reported in the interim financial statements.
• In determining the amount of inventory loss caused by casualty such as fire and
flood.
• In determining the reasonableness of inventory figures determined by the other
means (gross profit test).
• It is not acceptable in determining inventory amount to be reported in the year-end
financial statements.
2. Retail Inventory Method
• Based on an assumed relationship between cost and price
• Widely used by retail stores
• Records are maintained at two amounts – cost and retail.
 GROSS PROFIT METHOD
Beginning inventory P xxx

Add: Net cost of purchases xxx

Cost of goods available for sale P xxx

Less: Estimated cost of goods sold

(a) GPR is based on sales : Net sales x (100% - GPR)

(b) GPR is based on cost : Net sales / (100% + GPR) xxx

Estimated cost of ending inventory P xxx

BASED ON SALES BASED ON COST

NET SALES 100 % 140%

COGS 60% 100%

GROSS PROFIT 40% 40%

 GROSS PROFIT METHOD
If there are undamaged or partially damaged merchandise,
computation of inventory loss is as follows:

Estimated cost of ending inventory P xxx

Less: Cost of undamaged merchandise P xxx

Realizable value of partially

damaged inventory (but not to
exceed cost) xxx xxx
Estimated inventory loss P xxx
ANSWER
ANSWER
PROBLEM 3

ABC Corp. lost considerable part of its inventory on a fire on October 31. As the auditor, you were requested to make an estimate as to the total damages in
inventories caused by the fire.
Upon inquiry and inspection of records you ascertained the following:
Merchandise inventory, January 1 P120,000
Purchases, January 1 to October 31 830,000
Purchases returns and allowances 10,000
Transportation in 20,000
Sales, January 1 to October 31 1,096,000
Sales returns 40,000
Sales allowance 20,000
Sales discount 50,000
Employee discounts 24,000
Merchandise not damaged by fire on October 31 48,000

Requirements:
1. Using the gross profit test, what was the estimated loss in inventory due to the fire assuming that the gross profit rate is 30% based on sales?

2. Using the gross profit test, what was the estimated loss in inventory due to the fire assuming that the gross profit rate is 25% based on cost?
 RETAIL INVENTORY METHOD
Gross profit Method Retail Inventory Method

TGAS @ cost XX TGAS @ retail

COGS XX Net sales

Inventory end XX Inventory end @ retail

Cost ratio

Inventory end @ cost

TOTAL GOODS AVAILABLE FOR SALE
COST RETAIL
Beginning inventory P xxx P xxx
Purchases xxx Xxx
Purchase returns (xxx) (xxx)
Purchase discounts (xxx)
Purchase allowance (xxx)
Freight in xxx
Abnormal losses (xxx) (xxx)
Departmental transfers in or xxx Xxx
debit
Departmental transfers out or (xxx) (xxx)
credit
Mark up XX
Mark up Cancellation (XX)

Mark down (XX)

Mark down cancellation XX
GOODS AVAILABLE FOR SALE XXX XXX
NET SALES
RETAIL
SALES P XXX

SALES RETURNS (XXX)

SALES ALLOWANCES
SALES DISCOUNTS
EMPLOYEE DISCOUNTS XXX
NORMAL LOSS XXX

COGS AT RETAIL (NET SALES) XXX

TYPES OF RETAIL INVENTORY
METHOD
TYPES OF RETAIL INVENTORY
METHOD
METHODS IN COMPUTING COST
RATIO
Beginning inventory Net mark up Net mark downs

FIFO excluded included included

Average included included included

Conservative/conventional included included excluded

PROBLEM
ANSWER