Chapter 2 Inventories
Related standard: PAS 2 Inventories
Example of inventories:
-Merchandise purchased by a trading entity
and held for resale.
-Land and other property held for sale in the
ordinary course of business.
-Finished goods, goods undergoing production,
and raw materials and supplies awaiting use in
production process by a manufacturing entity.
*Ordinary course of business means usual
business activities of an entity
Recognition and Ownership over inventories
-Inventories are recognized when they meet the
definition of inventory and they qualify as
assets, such as when legal title is obtained by
the buyer from the seller.
-Legal title normally passes when possession
over of the goods is transferred.
-However, there may be cases where the
transfer of control (ownership) does not
coincide with the transfer of physical
possession.
-All inventories over which it holds legal title to
or has obtained control must be reported in the
entity’s financial statements regardless of its
location.
In this regard, proper consideration should be
given to the following 👉next slide
1. Goods in Transit
-Pertain to the goods already shipped by the
seller but are not yet received by the buyer.
-Depending on terms of sales contract, goods
in transit may form part of either buyer or
sellers inventories. Such terms are either
-FOB shipping point, ownership over the goods
is transferred upon shipment.
-FOB destination, ownership over the goods is
transferred only when the buyer receives the
goods.
👉FOB stands for “free on board
👉Sale contracts may also contain terms for
shipping costs indicated by any of the
following. Next slide👉
Freight collect- Freight is not yet paid upon
shipment. The carrier collects shipping costs
from the buyer upon delivery.
Freight prepaid- The seller pays the freight in
advance before shipment.
FAS (free alongside)- The seller assumes all
the expenses in delivering the goods to the
docks next to the carrier. The buyer assumes
loading and shipping costs. Title passes upon
shipment to the carrier.
Ex-ship- the seller assumes all expenses intil
the goods are unloaded from the carrier, at
which time title passes to the buyer.
CIF (cost, insurance, freight)–the buyer pays in
lump sum the CIF.
CF (cost and freight)- the buyer pay the cost of
the goods and the freight cost.
👉In either CIF or CF, the seller must deliver the
goods to the carrier and pay the costs of
loading. Thus, title passes to the buyer upon
delivery of the goods to the carrier.
👉As a rule, the entity who owns the goods
being shipped should pay for the shipping
costs.
Term of Sales Contract
No special accounting is necessary
in either:
FOB shipping point, Freight collect.
FOB destination, Freight prepaid.
The owner pays freight charges of the goods in
transit.
Special accounting arises in either:
FOB shipping point, Freight prepaid.
FOB destination, Freight collect.
The owner doesn’t pay for freight charges of
the good in transit.
2. Consigned Goods
A consignment involves a consignor
transferring the goods to a consignee who acts
as agent of the consignor in selling the goods.
Consigned goods are included in the
consignor’s inventory and are excluded from
the consignee’s inventory.
Ownership is not transferred to the consignee.
Transfer of consigned goods are recorded
through memorandum entries.
Freight and other incidental costs form part of
cost of the consigned goods.
Commission based sale.
3. Inventory financing agreements
Inventories may be acquired or sold under
various forms of financing agreements, which
may include the following:
Product financing agreement
The seller sells inventory to a buyer but
assumes an obligation to repurchase it at a
later date.
This arrangement does not result to a transfer
of control over the asset.
The seller retains the ownership over the
inventory.
B. Pledge of inventory
A borrower uses its inventory as a collateral
security for a loan.
It does not result to a transfer of control over
the asset.
The borrower retains ownership over the
inventory.
👉 Warehouse financing – under this
arrangement, a third party (e.g., public
warehouse) holds the inventory and acts as the
creditor’s agent. The public warehouse then
furnishes the creditor the warehouse receipts
evidencing rights to the inventory.
C. Loan of Inventory
An entity borrows inventory from another entity
to be replaced with the same kind of inventory.
Results to a transfer of control over the asset.
The borrower includes the loaned goods in its
inventory.
4. Sale with unusual right of return
The buyer normally recognizes goods
purchased under a sale with right of return at
the time of sale. Unless the goods purchased
does not qualify for recognition as asset. For
example, the buyer does not recognize any
inventory when:
The buyer assesses that no economic benefits
will be derived from the goods because they
are defective or unsalable.
The buyer intends to return the goods to the
seller within the time limit allowed under the
sale agreement.
5. Sale on trial (or approval)
A seller allows a prospective buyer to use a
good for a given period of time.
If the buyer is satisfied with the good, he
purchases it. If not, he returns it to the seller.
The legal title over the goods does not pass to
the buyer until the buyer purchases it. The
same as the buyer does not include it to his
inventory until he purchases the good.
The goods are considered as sold if it is not
returned within the given period of time.
6. Installment sale
The possession of the goods is transferred to
the buyer but the seller retains legal title solely
to protect the collectability of the amount due
is considered as a regular sale.
Therefore, the goods are excluded from the
seller’s inventory and included in the buyer’s
inventory at the point of sale.
7. Bill and hold arrangememt
Is a contract of sale 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.
The goods are excluded from the seller’s
inventory and included in the buyer’s inventory
upon billing, provided:
👉The reason for the bill and hold arrangement
is substantive.
👉The goods are available for immediate
transfer to the customer; and
👉The seller cannot use the goods or sell them
to another customer.
Lay away sale
Is a type of sale in which goods are delivered
only when the buyer makes the final payment in
a series of installments.
It is different from a regular installment sale
where in the goods are delivered at the time of
sale.
The goods are included in the seller’s inventory
until the goods are delivered to the buyer.
Delivery is made when the final installment
payment is paid.
The buyer may include the good in his
inventory when there is significant payments
that have been made, provided that delivery is
probable.
Summary to remember:
Type of arrangement
FOB shipping point
FOB destination
Consigned goods
Inventory financing
Sale with unusual right of return
Sale on trial (or approval)
Installment
Bill and hold
Lay away
Included in the inventory of
👉Buyer
👉Seller
👉Consignor
👉Borrower
👉Buyer, except when unsalable
👉Seller
👉Buyer
👉Buyer
👉Seller
Financial Statement
Presentation
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 is disclosed in the notes.
Inventories are classified as current assets.
Accounting for inventories
The major objectives of inventory accounting
are:
Proper determination of periodic income
through the recognition of appropriate costs
which are matched with revenue.
Proper representation of inventories
recognized as asset in the financial
statements.
👉Inventories are accounted for either through:
Perpetual Inventory System
Periodic Inventory System
Perpetual inventory system
The “inventory“ account is updated each time a
purchase or sale is made.
The “inventory” account shows continuing or
running balance of the goods on hand.
Maintenance of stock cards and stock ledgers.
Without the need of physical count.
All increases and decreases in inventory are
recorded in the “Inventory” account.
Commonly used for specifically identifiable and
relatively high valued inventories.
Periodic inventory system
Increases and decreasen in inventory during
the period are recorded in the purchases,
freight-in, purchase returns, and purchase
discounts.
Cost of Goods Sold is not recorded
Physical count is necessary to determine the
balances of inventory on hand and cost of
goods sold.
Requires the use of the following formula when
determining the cost of goods sold.
Inventory Shortages/Overages
-When an entity uses a perpetual inventory
system and a difference exist between the
perpetual inventory balance and the physical
inventory count, there is inventory shortage or
overage.
-Inventory shortage is charged to cost of goods
sold if it is considered normal spoilage, if
abnormal (theft) it is charged as loss.
-Periodic inventory system does not report the
account Inventory shortage/overage because it
subsumes them in the cost of goods sold.
(or Inventory shortage or overage)
INVENTORY ERRORS UNDER THE PERIODIC
SYSTEM
-The cost of goods sold as the residual amount
is affected by errors in ending inventory as well
as beginning inventory and net purchases.
-When the cost of goods sold is misstated, so
is the profit for the period.
-The following relationship between accounts
can provide guidance in determining the
effects of inventory errors on profit or loss
under a periodic system.
👉Ending inventory : Profit – Direct relationship
👉Beginning inventory & Purchases : Profit –
Inverse Relationship
👉Ending inventory : Cost of goods sold –
Inverse relationship
👉Beginning inventory & Purchases : Cost of
goods sold – Direct relationship
Measurement
-Inventories are measured at lower of cost and
net realizable value. (LCNRV)
Cost of inventories comprises the following :
A. Purchase cost- this includes the purchase
price(net of trade discount and other rebates),
import duties, non-refundable or non-
recoverable purchase taxes, and trasport,
handling and other cost directly attributable to
the acquisition of the inventory.
Value-Added Taxes are not included for in the
purchase cost of VAT payers because it is
recoverable. But it is included in the purchase
costs of Non- VAT payer.
- Trade discounts, rebates and other similar
items are detucted in determining the purchase
costs.
B. Conversion costs- these refer to the costs
necessary in converting raw materials into
finished goods. Conversion costs include direct
labor and production overhead costs.
C. Other costs necessary in bringing the
inventories to their present location and
condition.
The following are excluded from the cost of
inventories and expensed outright:
a. Abnormal amounts of wasted materials,
labor or other production cost.
b. Selling costs, advertising and promotion
costs and delivery expense or freight-out.
c. Administrative overheads that are not
necessary.
d. Storage costs unless necessary.
Trade discounts and Cash discounts
Trade discounts
-Given to encourage orders in large quantities.
-They do not form part of the cost of inventory.
-They are deducted from the list price in order
to determine the invoice price.
-And are not recorded in the books of either the
buyer and seller.
Cash discounts
-Given to encourage promt payment.
-They are deducted from the invoice price in
order to determine the amount of net payment
required within the discount period.

ACCOUNTING FOR CASH DISCOUNTS
Two accounting methods for cash discounts :
A. Gross Method- The cost of inventory and
accounts payable are recorded gross of cash
discounts. Purchase discounts are recorded
under the “Purchase discounts” account only
when taken. Purchase discounts is deducted
from gross purchases when computing for net
purchases.
B. Net Method- The cost of inventory and
accounts payable are initially recorded net of
cash discounts, regardless of whether such
duscounts are taken or not.
-Purchase discounts not taken are recorded
under the “Purchase discounts lost” account
and included as part of “other expense” or as
“finance cost” (interest expense).
-Cash discounts not taken reflects penalties.
-Theoretically, the net method should be used.
However, the gross method is more commonly
used.
Conversion Costs
-Refer to or the sum of direct labor and
manufacturing overhead costs, which are
necessary in converting raw materials into
finished goods.
-On the other hand, prime costs refer to the
sum of direct materials and direct labor costs.
-Manufacturing overhead are costs of
production that are not directly traceable to
finished goods.
-Manufacturing overhead are subclassified
into:
a. Variable production overheads – are
indirect costs of production that vary
directly with the volume of production,
such as indirect materials and indirect
labor.
b. Fixed production overhead- are indirect
costs of production that remain
relatively constant regardless of the
volume of production such as
depreciation, maintenance of the factory
buildings and equipment and cost of
factory management and
administration.
ABSORPTION COSTING AND VARIABLE
COSTING
Absorption (full) costing- is a costing method
in which both fixed and variable production
overheads are included in cost of inventories.
Variable costing- is a costing method in which
only variable production overhead is included
in cost of inventories. Fixed production
overhead is expensed immediately.
PAS 2 -requires the use of absorption costing.
Variable costing is used only for internal
reporting purposes.
Joint and By-products
-A production process may result in more than
one product being produced simultaneously.
-Joint products are produced (i.e., main
product and a by product)
-When the conversion costs 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 stage in the
production process when the products become
separately identifiable, or at the completion of
production.
-Most by-products, by nature, are immaterial. In
this case, they are often measured at net
realizable value and this value is deducted
from the cost of the main product.
Standard cost system
-Standard costs are budgeted inventory unit
costs established to motivate optimal
productivity and efficiency. 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.
-A standard cost system is designed to alert
management when the actual costs of
production differ significantly from target or
standard cost. The use of a standard cost
system is allowed under PAS 2 for convenience
provided the results approximate cost.
Borrowing costs
-Borrowing costs(interest expense) forms part
of the cost of inventory only if it is incurred on
borrowings taken to finance the acquisition or
production of inventory that meets the
definition of a qualifying asset. A qualifying
asset is an asset that necessarily takes a
substantial period of time to get ready for its
intended use or sale. All other interests are
charged as expenses.
Deffered settlement terms
- When payment for purchases is deferred and
the arrangement effectively contains a
financing element, the difference between the
purchase price for normal credit terms and the
amount paid is recognized as interest expense
over the period of the financing.
👉see the book for more comprehensive
illustrations.
Cost of agricultural produce harvested from
biological assets
-Inventories comprising agricultural produce
harvested from biological assets are initially
measured at fair value less cost to sell at the
point of harvest in accordance with PAS 41
Agriculture. This will be deemed cost for
subsequent measurement at the lower of cost
and net realizable value using PAS 2.
Cost of inventories purchased in lump sum
-The cost of different inventories having
different values purchased on a lump sum
basis is allocated to the inventories based on
their relative sales prices.
👉see the book for more comprehensive
illustrations.
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. Proper determination of such
costs may be obtained by selecting an
appropriate cost formula.
-The cost formulas only refer to “cost flow
assumptions”, and not necessarily the physical
flow of the entity that may vary.
-PAS 2 does not permit the use of last-in, first-
out (LIFO) cost formula.
1. Specific Identification
-This shall be used for inventories that are not
ordinarily interchageable and those that are
segregated for specific projects.
-Under this formula, specific costs are
attributed to identified items of inventory.
Accordingly, cost of sales represents the
actual costs of the specific items sold while
ending inventory represents the actual costs of
the specific items on hand.
-Specific identification, however, is not
appropriate when inventories consist of a large
number of items that are ordinarily
interchageable.
2. First-In, First-Out (FIFO)
-Under this formula, it is assumed that
inventories that were purchased or produced
first are sold first, and therefore unsold
inventories at the end of the period are those
most recently purchased or produced.
-Accordingly, cost of sales represents costs
from earlier purchases while the cost of ending
inventory represents costs from the most
recent purchases.
-There are two ways or classifications of using
FIFO formula which are the FIFO periodic and
FIFO perpetual. Accordingly, both ways
produced the same outcome.
👉Illustration will be discussed by the
presenter.
Weighted Average
-Under this formula, cost of sales and ending
inventory are determined based on the
weighted average cost of beginning inventory
and all inventories purchased or produced
during the period. The average may be
calculated on a periodic basis or as each
additional purchase is made, depending upon
the circumstances of the entity.
-There are also two classifications of using the
Weighted Average method which are the
Weighted Average- periodic and Weighted
Average- perpetual (Moving Average) that
produces different outcomes of the costs of
ending inventory and the cost of goods sold.
👉Illustration will be discussed by the
presenter.
Net realizable value (NRV)
-Inventories are measured at the lower of cost
and net realizable value.
-Net realizable value is “the estimated selling
price in the ordinary course of the business
less the estimated costs of completion and the
estimated costs necessary to make the sale.
-NRV is different from fair value.
-The former is an entity-specific value and the
latter is not.
-Measuring inventories at LCNRV is in line with
the basic accounting concept that an asset
shall not be carried at an amount that exceeds
it recoverable amount.
-If the inventory exceed its recoverable amount,
the cost of inventory is written down to NRV on
an item by item basis.
-The amount of write-down is recognized as
expense.
Write-down of inventory
-Write-down of inventories are usually carried
out on an item by item basis, although in some
circumstances, it may be appropriate to group
similar items.
-It is not appropriate to write down inventories
on the basis of their classification.
-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. If the
cost of an inventory is lower than its NRV, no
write-down is necessary.
-Write-down of inventories are normally
charged to cost of goods sold.
-Material write-downs and those that arise
from abnormal losses are charged as loss.
👉Illustration will be discussed by the
presenter.
Write-down or raw materials
-Raw materials inventory is not written down
below cost if the finished goods in which they
will be incorporated are expected to be sold at
or above cost. If, however, this is not the case,
the raw materials are written down to their
NRV. The best evidence of NRV for raw
materials is replacement cost.
👉Illustration will be discussed by the
presenter.
Reversal of write-downs
-If the NRV subsequently increases, the
previous write-down is reversed. However, the
amount of reversal shall not exceed the
original write-down. This is so that the new
carrying amount amount is the lower of the
cost and the revised NRV.
👉Illustration will be discussed by the
presenter.
Purchase Commitments
- A firm purchase commitment is “an
agreement with an unrelated party, binding on
both parties and usually legally enforceable,
that
A. Specifies all significant terms, including
the price and timing of the transactions.
B. Includes a disincentive for non-
performance that is sufficiently large to
make perfromance highly probable.
-A contracting party under a purchase
commitment cannot cancel without suffering
penalty.
-The buyer must accept the goods even if it
become impaired and charges it as loss on
purchase commitment.
-Loss on purchase commitment is recognized
only in guaranteed future purchases.
-When the prices subsequently increases, the
buyer recognizes gain on purchase
commitment.
👉Illustration will be discussed by the
presenter.
T-Account analysis
-Most accounting problems can be solved
much easier using T-account analysis than
formulas.
-Common accounting problems regarding
inventory can be solved using T-accounts.
👉Illustration will be discussed by the
presenter.

Thank You😊