PAS 2 INVENTORIES

Objective

 PAS 2 prescribes the accounting treatment for inventories. A primary issue in accounting for inventories is the
determination of cost to be recognized as asset and carried forward until the related revenues are recognized.
PAS 2 provides guidance on the determination of the cost of inventories, including the use of cost formulas,
their subsequent measurement and recognition as expense.

Scope

 PAS 2 applies to all inventories except those that are accounted for under other standards. The measurement
provisions of PAS 2 do not apply to items not measured under lower of cost or net realizable value.
PAS 2 shall not be applied to the following:
a) Financial instruments
b) Biological assets and agricultural produce at point of harvest

The measurement provisions of PAS 2 do not apply to the following:

a) Inventories of producers of agricultural, forest, and mineral products to the extent that they are measured
at NRV
b) Inventories of commodity broker-traders measured at fair value less cost to sell

Definition of Inventories

Inventories are assets

a) Held for sale in the ordinary course of business.
b) In the process of production for such sale.
c) In the form of materials/supplies to be consumed in the production process or in the rendering of service.

Classes of Inventories
1. Merchandising business – merchandise inventories (definition (a) above).
2. Manufacturing business – Finished goods inventories (definition (a) above); Work in process inventories
(definition (b) above); Raw materials inventories and manufacturing supplies (definition (a) above).
3. Service business – Work in process inventories (definition (a) above).

Recognition

 Inventories are recognized when they meet the definition of inventory and they qualify for recognition as
assets, such as when legal title is obtained by the buyer from the seller.

 What goods shall be included in inventory?

All goods to which the entity has title shall be included in inventory, regardless of location
General Rule: the one who has possession has legal title.

Regarding this proper consideration should be given to the following:

1. Goods in transit

Sale term Point of transfer of

ownership

a.) FOB Shipping point - buyer Upon shipment

b.) FOB Destination – seller Buyer’s location

 Freight collect- buyer pays for the
freight
 Freight prepaid – seller pays for the
 freight
c.) Free alongside (FAS) Upon shipment to the carrier

d.) Cost, insurance, Freight (CIF) Upon delivery of the goods to the carrier

e.) Ex-ship When the goods are unloaded from the carrier

OWNER

2. Consigned cost
Consignor
a) Inventoriable cost
 Freight cost and other handling cost of goods out on consignment.
b)Non-inventoriable cost
 Freight cost if the consigned goods are returned to the consignor
 The original freight cost of returned consigned goods
 Storage cost and other reimbursable costs charge to consignor (expense)
 Freight cost to final customer

3. Inventory financing agreements

a) Sales with Repurchase Agreement Seller

b) Pledge of inventories Pledgor or borrower
c) Loan of inventory Borrower

4. Sale with unusual right of return Buyer

5. Sale on trial or approval Seller

6. Installment sale Buyer

7. Bill and hold sale Buyer

8. Lay-away sale Seller

Financial statement presentation

 Inventories shall be presented on the statement of financial position as one line item under the caption.
The composition of inventories (i.e., finished goods, work in process, raw materials, and manufacturing
supplies) are disclosed in the notes. Inventories are classified as current assets.

Accounting for inventories

1. Periodic inventory system

 Physical counting of goods on hand at the end of the accounting period to determine quantities, which are
then multiplied by the corresponding unit cost to get the inventory value.
 Commonly used for inventories that are normally interchangeable and are relatively low valued such as
groceries, hardware, medicines and office supplies.

2. Perpetual inventory system
 Inventory account is updated for each purchase and sale of inventory.
 Records called “stock cards” that show the perpetual balances of inventory and Cost of goods sold are
maintained.
  This system is commonly used for inventories that are specifically identifiable and are relatively high
valued such as cars, machineries, furniture and heavy equipment.

Inventory shortage or overage

 If at the end of the accounting period, a physical count indicates a different amount, an adjustment is
necessary to recognize any inventory shortage and overage.
 An inventory shortage is usually closed to cost of goods sold if it is considered normal spoilage.

Inventory errors under the periodic system

 Cost of goods sold is a residual amount, so it is affected by errors in ending inventory as well as
beginning inventory and net purchases.
 Commonly arise from careless oversight or neglecting to take the physical count.

Measurement of inventories
Inventories shall be initially measured at cost.

Cost of inventories
The cost of inventories shall comprise all costs of purchase, costs of conversion and other costs incurred in
bringing the inventories to their present location and condition.

1. Costs of purchase
The costs of purchase of inventories comprise the purchase price, import duties and other taxes (other
than those subsequently recoverable by the entity from the taxing authorities), and transport, 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 costs of purchase.
2. Costs of conversion
The costs of conversion of inventories include costs directly related to the units of production, such as
direct labor. They also include a systematic allocation of fixed and variable production overheads that are
incurred in converting materials into finished goods. Fixed production overheads are those indirect costs
 of production that remain relatively constant regardless of the volume of production, such as depreciation
and maintenance of factory buildings and equipment, and the cost of factory management and
administration. Variable production overheads are those indirect costs of production that vary directly, or
nearly directly, with the volume of production, such as indirect materials and indirect labor.

The allocation of fixed production overheads to the costs of conversion is based on the normal capacity of
the production facilities. Normal capacity is the production expected to be achieved on average over a
number of periods or seasons under normal circumstances, taking into account the loss of capacity
resulting from planned maintenance. The actual level of production may be used if it approximates normal
capacity. The amount of fixed overhead allocated to each unit of production is not increased as a
consequence of low production or idle plant. Unallocated overheads are recognized as an expense in the
period in which they are incurred. In periods of abnormally high production, the amount of fixed overhead
allocated to each unit of production is decreased so that inventories are not measured above cost.
Variable production overheads are allocated to each unit of production on the basis of the actual use of
the production facilities.

A production process may result in more than one product being produced simultaneously. This is the
case, for example, when joint products are produced or when there is a main product and a by-product.
When the costs of conversion of each product are not separately identifiable, they are allocated between
the products on a rational and consistent basis. The allocation may be based, for example, on the relative
sales value of each product either at the stage in the production process when the products become
separately identifiable, or at the completion of production. Most by-products, by their nature, are
immaterial. When this is the case, they are often measured at net realizable value and this value is
deducted from the cost of the main product. As a result, the carrying amount of the main product is not
materially different from its cost.

3. Other costs
Other costs are included in the cost of inventories only to the extent that they are incurred in bringing the
inventories to their present location and condition. For example, it may be appropriate to include non-
production overheads or the costs of designing products for specific customers in the cost of inventories.

Costs excluded from inventory:

a) abnormal amounts of wasted materials, labor or other production costs;
b) storage costs, unless those costs are necessary in the production process before a further production
stage;
c) administrative overheads that do not contribute to bringing inventories to their present location and
condition; and
d) selling costs.

Borrowing Costs identifies limited circumstances where borrowing costs are included in the cost of inventories.

An entity may purchase inventories on deferred settlement terms. When the arrangement effectively contains a
financing element, that element, for example a difference between the purchase price for normal credit terms
and the amount paid, is recognized as interest expense over the period of the financing.

Cost of inventories of a service provider

To the extent that service providers have inventories, they measure them at the costs of their production.
These costs consist primarily of the labor and other costs of personnel directly engaged in providing the service,
including supervisory personnel, and attributable overheads. Labor and other costs relating to sales and general
administrative personnel are not included but are recognized as expenses in the period in which they are
incurred. The cost of inventories of a service provider does not include profit margins or non-attributable
overheads that are often factored into prices charged by service providers.

Cost of agricultural produce harvested from biological assets

  In accordance with PAS 41 Agriculture  inventories comprising agricultural produce that an entity has
harvested from its biological assets are measured on initial recognition at their fair value less costs to sell at the
point of harvest. This is the cost of the inventories at that date for application of this Standard.

Techniques for the measurement of cost

Techniques for the measurement of the cost of inventories, such as the standard cost method or the retail
method, may be used for convenience if the results approximate cost. Standard costs take into account normal
levels of materials and supplies, labor, efficiency and capacity utilization. They are regularly reviewed and, if
necessary, revised in the light of current conditions.

The retail method is often used in the retail industry for measuring inventories of large numbers of rapidly
changing items with similar margins for which it is impracticable to use other costing methods. The cost of  the
inventory is determined by reducing the sales value of the inventory by the appropriate percentage gross
margin. The percentage used takes into consideration inventory that has been marked down to below its original
selling price. An average percentage for each retail department is often used.

Cost Formulas
 one of the major objectives of inventory accounting is the determination of costs of inventories recognized as
expense when the related revenues are recognized. This is important for the proper determination of periodic
income.

Cost Formulas
 Specific Identification
 First-In, First-Out (FIFO)
 Weighted Average

Specific Identification
 shall be used for items that are not ordinarily interchangeable or for items that are individually unique and
goods or services produced and segregated for specific projects.
 If there are large number items of inventory that are ordinarily interchangeable it is inappropriate to use
specific identification, instead it can use either FIFO or weighted average method.

First-In, First-Out (FIFO)

 is an asset-management and valuation method in which assets purchased or produced first are sold, used, or
disposed first, consequently, the items remaining in inventory at the end of the period are the most recently
purchased or produced.
 The FIFO formula can be used under either a periodic or perpetual inventory system. However, FIFO yields
the same amounts of cost of goods sold and ending inventory when applied in either a periodic or perpetual
system.

Weighted Average Cost Formula

Weighted Average Cost- Periodic (Simple Weighted Average)
 the weighted average cost is determined at the end of the period by using the following formula:

Weighted Average Cost = Total Goods Available for Sale in Peso

Total Goods Available for Sale in Units

Total Goods Available for Sale = Beginning Inventory + Net Purchases

Weighted Average Cost- Perpetual (Moving Average)

 determined after every purchase or as each shipment is received by dividing total goods available for sale as
of that date by the total quantity of goods available for sale as of that date. The moving average unit cost is then
multiplied by the quantity goods sold after the latest purchase to determine cost of goods sold or by the quantity
of inventory on hand to determine ending inventory.
FIFO-Periodic/Perpetual
Beginning Inventory in Units xx
Net Purchases in Units xx
Total Goods Available for Sale in Units xx

Total Goods Available for Sale in Units xx

Quantity of Goods Sold (xx)
Ending Inventory in Units xx

Total Goods Available for Sale in Peso xx

Ending Inventory at Cost (xx)
Cost of Goods Sold xx

Weighted Average- Periodic

The weighted average unit cost is computed as follows:

Weighted Average Unit Cost = Total Goods Available for Sale in Peso
Total Goods Available for Sale in Units

Ending Inventory in Units xx

Multiply by: Weighted Average Unit Cost xx
Ending Inventory at Cost xx

Total Goods Available for Sale in Peso xx

Ending Inventory at Cost (xx)
Cost of Goods Sold xx

Weighted Average-Perpetual
(Moving Average)

Weighted Average Cost = Total Goods Available for Sale in Peso

Total Goods Available for Sale in Units

Total Goods Available for Sale in Peso xx

Ending Inventory at Cost (xx)
Cost of Goods Sold xx

 PAS 2 doesn’t not permit the use of Last-In, First-Out (LIFO) cost formula.

Subsequent measurement of Inventories

Lower of Cost or Net Realizable Value

Determination of LCNRV Lower of Cost or NRV (LCNRV) is applied on an ITEM BY ITEM BASIS. This is
applied to all types of inventories except for RAW MATERIALS AND FACTORY SUPPLIES. These
items of inventories are tested for possible write-down only if the related finished goods are to be written
down.

This is all applied to all types of inventories except for raw materials and factory supplies

COST >NRV = there is inventory writedown

COST<NRV = There is reversal of inventory write-down if there is a previous inventory write-down

How to compute NRV?

Net Realizable Value (NRV)

• A.) Finished Goods/ Merchandise Inventory ESP – ECTS

• B.) Work in Process Inventories ESP – ECTS – ECTC

• C.) Raw Materials and Factory Supplies Current Replacement Cost

Accounting for Inventory Write-down

Direct method

The inventory is recorded at the lower of cost or net realizable value. This method is also known as "cost
of goods sold" method because any loss on inventory write- down is not accounted for separately but
"buried" in the cost of goods sold.

Allowance method

The inventory is recorded at cost and any loss on inventory write-down is accounted for separately. This
method is also known as "loss method" because a loss account, "loss on inventory write-down" is debited
and a valuation account "allowance for inventory write-down" is credited for the inventory write-down.

Allowance for Inventory Write-down

Reversal of Inventory Beginning

Loss on Inventory XX Balance XX

Write-down XX

Ending Balance
XX

NOTES:

1. The ending balance of allowance for inventory write-down is the difference between cost andd NRV of
the current end of accounting period.

2. Loss on inventory write-down is presented as addition to COGS or other losses if immaterial.

3. Gain on reversal of inventory write-down is up to the extent of allowance balance only and presented
as deduction against COGS.