Lesson 9

INVENTORIES
Learning Objectives
After studying the chapter, you should be able to
1. To understand the meaning of inventories
2. To identify the major classis of inventory
3. To account for inventory transactions using periodic and perpetual inventory system.
4. To know the gross method and net method of recording purchases.
5. To identify the items included in inventory cost.

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.

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

a. Merchandise purchased by a retailer and held for resale
b. Land and other property held for resale by a subdivision entity and real estate developer.

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

Note: It is important to identify the nature of the company,as stated above, if a company is a REAL ESTATE DEVELOPER ITS' MAIN SOURCE OF INCOME IS RESALE OF LANDS OR
BUILDINGS. NEEDLESS TO SAY, a BUILDING USED by A REAL ESTATE DEVELOPER to house it employess for work arrangement is NOT INVENTORY, since it is not for sale and used in
its daily operations.

Classes of inventories

Inventories are broadly classified into two, namely inventories of a trading concern and inventories of manufacturing concern.

A trading concern is one that buys and sells goods in the same form purchased. /Merchandising Business

The term “merchandise inventory” is generally applied to goods held by a trading concern./Manufacturing Business

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:

a. Finished goods
b. Goods in process
c. Raw materials
d. Factory or manufacturing supplies / Factory Overhead Costs

Proforma Cost of Goods sold Statement

Merchandising Business

Beginning Inventory XX
Purchases XX
Add: Freight In XX
Total XX
Less: Purchase Return, allowance and discount (XX)
Goods Available For Sale XX
Less: ENDING INVENTORY ( From Physical Count or Records) (XX)
Less: Inventory Writedown (XX)
Cost of Goods Sold/ Cost of Sales XX

Manufacturing Business

Beginning Inventory, Direct Raw Materials XX

Purchases XX
Add: Freight In XX
Total XX
Less: Purchase Return, allowance and discount (XX)
Less: ENDING INVENTORY, RAW MATS ( From Physical Count or Records) (XX)
Direct Raw Materials USED XX
DIRECT LABOR XX
Factory Overhead ( Indirect Materials and Labor) XX
Total Manufacturing Costs XX
Add: Work In Process, Beg XX
Less: Work In Process, End (XX)
Cost of Goods Manufactured XX
Finished Goods Inventory, Beginning XX
Cost of Goods Available For Sale XX
Less: Finished Goods Inventory, END (From Physical Count or Records) (XX)
Less: Inventory Writedown (XX)
Cost of Goods Sold/ Cost of Sales XX

Definitions

Finished goods completed products which are ready for sale.

Finished goods have been assigned their full share of manufacturing costs.

Goods in process or 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.

No work or process has been done on them as yet by the entity inventorying them.

Broadly, raw materials cover all materials used in the manufacturing operations.

However, frequently raw materials are restricted to materials that will be physically incorporated in the production of other the production process.

Factory or manufacturing supplies are similar to raw materials but their relationship to the end product is indirect.

Factory or manufacturing supplies may be referred to as indirect materials.

It is indirect because they are not physically incorporated in the products being manufactured.

There are other manufacturing supplies like paint and nails which become part of the finished product.

However, since the amounts involved are insignificant it is impractical to attempt to allocate their costs directly to the product.

These supplies find their way into the product cost as part of the manufacturing overhead.

Legal test

Is the entity the owner of the goods to be inventoried?

If the answer is in the affirmative, the goods shall be included in the inventory.

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:

a. Goods owned and on hand
b. Goods in transit and sold FOB destination
c. Goods in transit and purchased FOB shipping point
d. Goods out on consignment
G d i th h d f l t
Who owns the inventory?

When is ownership transferred?

Who must
who pays
Freight Terms Pay the
Upon the shipper?
shipping fee
Shipment/ Upon Delivery
Transit
FOB SHIPPING POINT, FREIGHT COLLECT BUYER BUYER BUYER BUYER
FOB SHIPPING POINT, FREIGHT PREPAID BUYER BUYER BUYER SELLER
FOB DESTINATION,FREIGHT PREPAID SELLER BUYER SELLER SELLER
FOB DESTINATION,FREIGHT COLLECT SELLER BUYER SELLER BUYER
FAS or free alongside(Upon Dock) BUYER(Dock) BUYER(Dock) BUYER BUYER
CIF or Cost, insurance and freight SELLER BUYER SELLER SELLER

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

Entries upon Shipment

Freight Terms Buyer's book Seller's book
Purchases 100,000 Cash/AR 100,000
FOB SHIPPING POINT, FREIGHT COLLECT, Amount
Freight In 5,000 Sales 100000
100,000 , Shipping Costs 5,000
Cash/AP 105,000
Purchases 100,000 Cash/AR 105,000
FOB SHIPPING POINT, FREIGHT PREPAID, Amount
Freight In 5,000 Sales 100000
100,000 Shipping Costs 5,000
Cash/AP 105,000 Cash 5,000
Purchases 100,000 Cash/AR 100,000
FOB DESTINATION,FREIGHT PREPAID, Amount 100, Cash/AP 105,000 Freight Out 5000
000, Shipping Costs. 5,000 Sales 100000
Cash 5000
Purchases 100,000 Cash/AR 95,000
FOB DESTINATION,FREIGHT COLLECT, Amount 100,
Cash/AP 95000 Freight Out 5,000
000, Shipping Costs. 5,000
Cash/AP 5,000 Sales 100,000

Consigned goods

A consignment is a method of marketing goods 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 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.

For example, a consignee sells consigned goods for P100,000. This amount is remitted to the consignor less commission of P15,000 and advertising of P2,000.

The consignor simply records the cash remittance from the consignee as follows:

Cash 83,000
Commission 15,000
Advertising 2,000
Sales 100,000

Incidentally, 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.

For example, the note shall disclose the composition of the inventories of a manufacturing entity as finished goods, goods in process, raw materials and manufacturing supplies.

Accounting inventories

Two systems are offered in accounting for inventories, namely periodic system and perpetual system.

The periodic system 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. This approach gives actual or physical inventories.
The periodic inventory procedure is generally used when the individual inventory items have small peso investment, such as groceries, hardware and auto parts.

On the other hand, the 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. This approach gives book or perpetual inventories.

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.

Consequently, the entity would be able to know the inventory on hand at a particular moment in time.

In recent years, the widespread use of computers has enabled practically all large trading and manufacturing entities to maintain a perpetual inventory system.

With computers, the entities can conveniently and effectively store and retrieve large amount of inventory data.

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.

Entries upon Shipment

Business Transactions Periodic Perpetual

Purchase of merchandise on account, P300,000 Purchases 300,000 Merchandise Inventory 300,000
Accounts Payable 300,000 Accounts Payable 300,000
Payment of freight on the purchase, P20,000 Freight In 20,000 Merchandise Inventory 20,000
Cash 20,000 Cash 20,000
Return of merchandise purchased to supplier, P30, Accounts Payable 30,000 Accounts Payable 30,000
000 Purchase Return 30,000 Merchandise Inventory 30,000
Sale of merchandise on account, P400,000, P40% Accounts Receivable 400,000 Accounts Receivable 400,000
gross Sales 400,000 Sales 400,000

Cost of goods Sold 240,000

Merchandise Inventory 240,000
Return of merchandise sold from customer, P25, Sales Return 25,000 Sales Return 25,000
000 Accounts Receivable 25,000 Accounts Receivable 25,000

Merchandise Inventory 15,000

Cost of goods Sold 15,000
Adjustment of ending inventory, P65,000 Merchandise Inventory - end 65,000 No entry
Income Summary 65,000
if the physical count shows inventory on hand of Inventory Shortage 10,000 Inventory Shortage 10,000
P55,000 Merchandise Inventory 65,000 Merchandise Inventory 65,000

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.
Thus, 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 discounts is to encourage prompt payment.
Cash discounts are recorded as purchase discount by the buyer and sales discount by the seller.

Purchase discount is deducted from purchases to arrive at net purchases and sales discount is deducted from sales to arrive at net sales revenue.

Illustration

The list price of a merchandise purchased is P500,000, less 20% and 10%, with credit terms of 5/10, n/30.

This means that trade discounts are 20% and 10%, and the cash discount is 5% if payment is made in 10 days.

The full amount of the invoice is paid if the payment is made after 10 days and within the credit period of 30 days.

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

Gross method vs. net method

Business Transactions Gross method Net Method

Purchase of merchandise on account, P200,000, Purchases 200,000 Purchases 196,000
2/10, n/10 Accounts Payable 200,000 Accounts Payable 196,000
Assume payment is made within the discount Accounts Payable 200,000 Accounts Payable 196,000
period. Cash 196,000 Cash 196,000
Purchase Discount 4,000
Assume payment is made beyond the discount Accounts Payable 200,000 Accounts Payable 196,000
period. Cash 200,000 Purchase Discount lost 4,000
Merchandise Inventory 200,000
Assume it is in the end of accounting period, no Purchase discount lost 4,000
payment is made and the discount period has Accounts Payable 4,000
expired

Cost of inventories

The cost of inventories shall comprise

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

The cost of purchase of inventories 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.

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
 , p , p p p g
expense over the period of financing.

Prime Cost is equal to Direct Materials and Direct Labor

Cost of conversion

The cost of conversion of inventories 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.

Conversion Cost is equal to Direct Labor and Factory Overhead

Allocation of fixed production overhead

The allocation of fixed production overhead to the cost 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 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 separately 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.

Other cost

Other cost is included in the cost of inventories 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.

However, the following costs are 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 process 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

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 in the period in which they incurred.