INVENTORIES

Inventories are assets:

a. held for sale in the ordinary course of business,
b. in the process of production for such sale or
c. in the form of materials or supplies to be consumed in the production or in the rendering
of services.

Typical examples of inventories include:

1. merchandise purchased by a retailer and held for resale,
2. finished goods produced,
3. work in progress being produced or
4. materials and supplies awaiting use in the production process
5. Land and Other property held for resale by a subdivision entity and real estate developer.

Classes of inventories

1. Inventories of a trading concern - is one that buys and sells “merchandise inventory” in
the same form purchased.

2. Inventories of manufacturing concern - is one that buys which are altered or converted
into another form before they are made available for sale.
a. Finished goods
- are completed products which are ready for sale.
- have been assigned their full share of manufacturing costs.
b. Goods in process or work in process are partially completed products which
require further process or work before they can be sold
c. Raw Materials
- are goods to be used in the production and no work or process has been
done on them as yet by the entity inventorying them.
- Frequently are restricted to materials that will be physically incorporated
in the production of other goods and can be directly traced to the end
product
d. Factory or manufacturing supplies are indirect materials or not normally physically
incorporated (ex. Paint and nails) in the products being manufactured. Cost
attributable shall form part of manufacturing overhead since amounts involved
are insignificant.

Goods includible in the inventory

As a rule, all goods to which the entity has title shall be included in the inventory,
regardless of location. The phrase "passing of title" is a legal language which means "the point of
time at which ownership changes.”
Legal test: Is the entity the owner of the goods to be inventoried?
a. If the answer is in the affirmative, the goods shall be included in the inventory.
b. If the answer is in the negative, the goods shall be excluded from the inventory.

Applying the legal test, the following items are includible in inventory, goods:
• Owned and on hand • Out on consignment
• In transit and sold FOB destination • In the hands of salesmen or agents
• In transit and purchased FOB • Held by customers on approval or on
shipping trial

Exception to the legal test

1. Installment contracts may provide for retention of title by the seller until the selling price
is fully collected.

2. The goods sold on installment basis are still the property of the seller and therefore
normally includible in his inventory.
However, in such a case, it is an acceptable accounting procedure to record the
installment sale as a regular sale involving deferred income on the part of the seller and
as a regular purchase on the part of the buyer. Thus, goods are excluded from the seller.

Who is the owner of goods in transit?

1. FOB destination, ownership of goods purchased is transferred only upon receipt of the
goods by the buyer at the point of destination. Goods in transit are still the property of
the seller and is responsible for freight charges and other expenses up to the point of
destination.
2. FOB shipping point, ownership is transferred upon shipment of the goods and therefore,
the goods in transit are the property of the buyer who shall be legally responsible for
freight charges and other expenses from the point of shipment to the point of destination.

In practice, during an accounting period, the accountant normally records:

a. Purchase when goods are received and
b. Sales when goods are shipped, regardless of the precise moment at which title passed.

However, the accountant should carefully analyze the terms of goods that are in transit at
the end of the period to determine who has legal title. Accordingly, adjustments are in order if
errors are committed in recording purchases and sales.

Freight terms

Freight collect — This means that the freight charge on the shipped is not yet paid. The common
carrier shall collect the same from the buyer. Thus, under this, the freight charge is actually paid
by buyer.
Freight prepaid — This means that the freight charge on the goods shipped is already paid by the
seller.

Maritime shipping terms

FAS or free alongside — A seller who ships FAS must bear all expenses and risk involved in
delivering the goods to the dock next to or alongside the vessel on which the goods are to be
shipped.
The buyer bears the cost of loading and shipment and thus, title passes to the buyer when
the carrier takes possession of the goods

CIF or Cost, insurance and freight — the buyer agrees to pay in a lump sum the cost of the goods,
insurance cost and freight charge.
The shipping contract may be modified as CF which means that the buyer agrees to pay
in a lump sum the cost of the goods and freight charge only.
In either case, the seller must pay for the cost of loading. Thus, title and risk of loss shall
pass to the buyer upon delivery Of the goods to the carrier

Ex-ship — A seller who delivers the goods ex-ship bears expenses and risk of until the goods are
unloaded at which time title and risk of loss shall pass to the buyer.

Consigned goods
• A consignment is a method of marketing in which the owner called the consignor
transfers physical possession of certain goods to an agent called the consignee who sells
them on the owner’s behalf.
• Consigned goods shall be included in the consignor's inventory and excluded from the
consignee's inventory.
• Freight and other handling charges on goods out on consignment are part of the of goods
consigned.
• When consigned goods are sold by the consignee, a report is made to the consignor
together with a cash remittance for the amount of sales minus commission and other
expenses chargeable to the consignor.
• Consigned goods are recorded by the consignor by means of a memorandum entry.

Statement presentation
• Inventories are generally classified as current assets.
• The inventories shall be presented as one line item in the statement of financial position
but the details of the inventories shall be disclosed in the notes to financial statements.
• Example, based from the Audited Financial Statements (AFS) of SM Prime, Real estate
inventories includes Land and Development, Condominium Units for Sale and Residential
Units and Subdivision Lots.
 Accounting for inventories

Two systems are offered in accounting for inventories, namely

1. Periodic system (Actual/ Physical Inventories) - calls for the physical counting of goods
on hand at the end of the accounting period to determine quantities. The quantities are
then multiplied by the corresponding unit costs to get the inventory value for balance
sheet purposes.

2. Perpetual system - requires the maintenance of records called stock-cards that usually
offer a running summary of the inventory inflow and outflow.
Inventory increases and decreases are reflected in the stock cards and the
resulting balance represents the inventory. The perpetual inventory procedure is
commonly used where the inventory items treated individually represent a relatively
large peso investment such as jewelry and cars.
In an ideal perpetual system, the stock cards are kept to reflect and control both
units and costs.
In years, the widespread use of computers has enabled practically all large trading
and manufacturing entities to maintain a perpetual inventory system.
When the perpetual system is used, a physical count of the units on hand should
at least be made once a year to confirm the balances appearing on the stock cards
 Inventory shortage or overage

In the illustration, the merchandise inventory account has debit balance of P65,000. If at
the end of the accounting period, a physical count indicates a different amount, an adjustment
is necessary to recognize any inventory shortage or overage,

For example, if the physical count' shows inventory on hand of P55,000 the following adjustment
is necessary:
Inventory shortage 10,000
Merchandise inventory (65,000 - 55,000) 10,000

The inventory shortage 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
shall be separately classified and presented as other expense.

Trade discounts and cash discounts

Trade discounts - are deductions from the list or catalog price in order to arrive at the invoice
price which is the amount actually charged to the buyer. Trade discounts are not recorded.
The purpose of trade discounts is to encourage trading or increase sales. Trade discounts
also suggest to the buyer the price at which the goods may be resold.

Cash discounts are deductions from the invoice price when payment is made within the discount
period. The purpose of cash is to encourage prompt payment. Cash discounts are recorded as
purchase discount by the buyer and sales discount by the seller.

Illustration: The list price of a merchandise purchased is P500,000 less 20% and 10%; 5/10, n/30
List price 500,000
First trade discount (20% x 500,000) -100,000
400,000
Second trade discount (10% x 400,000) -40,000
INVOICE PRICE 360,000
Cash discount (5% x 360,000) -18,000
Payment within the discount period 342,000

Entry to record purchase and payment:

Purchases 360,000
Accounts payable 360,000
Accounts payable 360,000
Cash 342,000
Purchase discount 18,000
 METHODS OF RECORDING PURCHASE
1. Gross Method – purchases and accounts payable are recorded at gross
2. Net Method - purchases and accounts payable are recorded at net

ILUSTRATION:

Technically, the gross method violates the matching principle because discounts are
recorded only when taken or when cash is paid rather than when purchases that give rise to the
discounts are made.

The gross method is more convenient than the net method from a bookkeeping standpoint.
Moreover, if applied over time, it usually produces no material errors in the financial statements.

Cost of inventories
a. Cost of purchase
b. Cost of conversion
c. Other cost incurred in bringing the inventories to their present location and condition

Cost of Purchase
• Purchase price • Freight
• Import duties and irrecoverable • Handling
taxes
• 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 of
purchase. The cost of purchase shall not include foreign exchange differences which arise directly
from the recent acquisition of inventories involving a foreign currency.
 Moreover, when inventories are purchased with deferred settlement terms, the
difference between the purchase price for normal credit terms and the amount paid is recognized
as interest expense over the period of financing.

Cost of conversion
• 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 administra tion.
Variable production overhead is the indirect cost of production that varies directly
with the Volume of production. Examples are indirect labor and indirect materials.

Allocation of fixed production overhead

The allocation of fixed production overhead to the cost of is based on the normal capacity
of the production facilities.

Normal capacity is the production expected to 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 amount of fixed overhead allocated to each unit of production is not increased as
consequence of low production or idle plant.

Unallocated fixed overhead is recognized as expense in the period in which it is incurred.

Allocation of variable production overhead

Variable production overhead is 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 where there is a main
product and a by-product.

When the costs of conversion are not identifiable, they are allocated between the
products on a rational and consistent basis, for example, on the basis of the relative sales value
of each product.
Most by-products by their nature are not material. By-products are measured at net
realizable value and this value is deducted from the cost of the main product.

Other cost
Included in the cost of inventories only to the extent that it is incurred in bringing the
inventories to their present location and condition.
Example:
• It may be appropriate to include the cost of designing product for specific customers in
the cost of inventories.

Excluded from the cost of inventories and recognized as expenses in the period when incurred:
a. Abnormal amounts of wasted materials, labor and other production costs.
b. Storage costs, unless these costs are necessary in the production prior to a further
production stage. Thus, storage costs on goods in process are capitalized but
storage costs on finished goods are expensed.
c. Administrative overheads that do not contribute to bringing inventories to their
present location and condition.
d. Distribution or selling costs

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
and attributable overhead.

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 incurred.