CHAPTER 9-15 Intermediate Accounting

INTERMEDIATE ACCOUNTING VOLUME 1
CHAPTER 9-RECEIBVABLE FINANCING (Discounting of note receivable)

Concept of discounting
As a form of receivable financing, discounting specifically pertains to note
receivable.
In a promissory note, the original parties are the maker and payee.
The maker is the one liable and the payee is the one entitled to payment on the date
of maturity.
When the note is negotiable, the payee may obtain cash before maturity date by
discounting the note at a bank or other financing company.
To discount the note, the payee must endorse it.
Thus, legally the payee becomes an endorser and the bank becomes an
endorsee.
Endorsement
Endorsement is the transfer of right to a negotiable instrument by simply signing at
the back of the instrument.
Endorsement maybe with recourse which means that the endorser shall pay the
endorsee if the maker dishonors the note.
In the legal parlance, this is the secondary liability of the endorser.
In the accounting parlance, this is the contingent liability of the endorser.
Endorsement may be without recourse which means that the endorser avoids
future liability even if the maker refuses to pay the endorsee on the date of maturity.
In the absence of any evidence to the contrary, endorsement is assumed to be with
recourse.
Terms related to discounting of note

1. Net proceeds refer to the discounted value of the note received by the
endorser from the endorsee.
Net proceeds = Maturity value minus Discount
2. Maturity value is the amount due on the note at the date of maturity. Principal
plus interest equals the maturity value.
3. Maturity date is the date on which the note should be paid.
4. Principal is the amount appearing on the face of the note. It is also referred to
as face value.
5. Interest is the amount of interest for the full term of the note. Interest is
computed as Principal x rate x time.
6. Interest rate is the rate appearing on the face of the note.
7. Time is the period within which interest shall accrue. For discounting
purposes, it is the period from date of note to maturity date.
In other words, the term “time” is the entire period or “full term” of the note.
8. Discount is the amount of interest deducted by the bank in advance.
Discount is equal to maturity value times discount rate times discount
period.
9. Discount rate is the rate used by the bank in computing the discount. The
discount rate should not be confused with the interest rate. The discount rate
and interest rate are different from each other.
If no discount rate is given, the interest rate is safely assumed as the discount
rate.
10. Discount period is the period of time from date of discounting to maturity
date.
Simply computed, discount period equals term of the note minus the expired
portion up to the date of discounting. The discount period is the unexpired
term of the note.
 Maturity value which is equal to the principal plus interest.

 Observe that the interest must be for the “full term” of the note in determining the
maturity value.
 Discount which is equal to the “maturity value times discount rate times
discount period”.
 The discount period is the remaining term of the note on the date of
discounting.
 In counting, “exclude the first day but include the last day.”
 The difference between the net proceeds from discounting and the carrying
amount of the note receivable is recognized as gain or loss.
 The accounting for note receivable discounting depends in whether the
discounting is with or without recourse.
 The discounting is without recourse, meaning, the sale of the note receivable is
absolute and therefore there is no contingent liability.
 The note receivable account is credited directly because the sale of the note
receivable is without recourse or absolute.
 The interest income is credited for the actual interest earned on the date of
discounting.
 If the discounting is with recourse, the transaction is accounted for as either of
the following:
a. Conditional sale of note receivable recognizing a contingent liability
b. Secured borrowing
 The note receivable discounted account is deducted from the total notes
receivable when preparing the statement of financial position with disclosure of
the contingent liability.
 If the discounting is treated as a secured borrowing, the note receivable is not
recognized but instead an accounting liability is recorded at an amount equal to
the face amount of the note receivable discounted.
 There is no objection if the interest expense is “netted” against the interest

income or a net interest expense because the discounting transaction is a
borrowing.
 There is no gain or loss on discounting if the note receivable discounting is
accounted for as secured borrowing.
 If the note is paid by the maker to the First Bank, the liability for note receivable
discounted and note receivable are derecognized.
 PFRS 9, paragraph 3.2.3, provides that an entity shall derecognize a financial
asset when either one of the following criteria is met:
a. The contractual rights to the cash flows of the financial asset have expired.
b. The financial asset has been transferred and the transfer qualifies for
derecognition based on the extent of transfer of risks and rewards of
ownership.
 The first criterion is usually easy to apply.
- The contractual rights to the cash flows may expire, for example, when a note
receivable from a customer is fully collected.
 The application of the second criterion is often complex.
- It relies on the assessment of the extent of the transfer of risks and rewards of
ownership.
 PFRS 9, paragraph 3.2.6, provides the following guidelines for derecognition
based on transfer of risks and rewards.
1. If the entity has transferred substantially all risks and rewards, the financial
asset shall be derecognized.
2. If the entity has retained substantially all risks and rewards, the financial
asset shall not be derecognized.
3. If the entity has neither transferred nor retained substantially all risks and
rewards, derecognition depends on whether the entity has retained control
of the asset.
a. If the entity has lost control of the asset, the financial asset is
derecognized in its entirety.
b. If the entity has retained control over the asset, the financial asset is not
derecognized.
 Unquestionably, the contractual rights to the cash flows of the note receivable
discounted with recourse have not yet expired. Thus, this first criterion does not
apply.
 The discounting of note with recourse does not also fall squarely within a single
guideline in the second criterion of “transfer of risks and rewards of ownership”.
 The discounting transaction is a combination of the guidelines in the second
criterion as follows:
a. The entity has substantially transferred all “rewards”.
b. The entity has retained substantially all “risks”.
c. The entity has lost control of the note receivable.
 Much debate on this accounting issue can go on among academicians and
theoreticians until a clearcut interpretation of the standard is made by the
Financial Reporting Standards Council.
 Premises considered, it is believed that the discounting of note receivable with

recourse is to be accounted for as a conditional sale with recognition of a
contingent liability.
 The main justification is that upon discounting or endorsement of the note
receivable, whether with or without recourse, the transferor or endorser has lost
control over the note receivable.
 Accordingly, the transferee has complete control over the note receivable
because the transferee has the practical ability to sell the asset to a third party
without attaching any restrictions to the transfer.
MULTIPLE CHOICE
1. If a note receivable is discounted with recourse
a. A contingent liability does not exist.
b. Note receivable discounted is credited.
c. Liability for note receivable discounted is credited.
d. Note receivable must be credited.
2. The note receivable discounted account is reported as

a. Contra asset account for the proceeds from discounting
b. Contra asset account for the face amount of the note
c. Liability account for the proceeds from the discounting
d. Liability account for the face amount of the note
3. If a note receivable is discounted without recourse

a. The contingent liability may be disclosed
b. Liability for note receivable discounted is credited
c. Note receivable is credited
d. The transaction is a secured borrowing
4. Note receivable discounted with recourse should be

a. Excluded from total receivables without disclosure
b. Excluded from total receivables with disclosure
c. Included in total receivables without disclosure
d. Included in total receivables with disclosure
5. After being held for 40 days, a 120-day 12% interest bearing note receivable was
discounted at a bank at 15%. The net proceeds from discounting are equal to
a. Maturity value less the discount at 12%
b. Maturity value less the discount at 15%
c. Face amount less the discount at 12%
d. Face amount less the discount at 15%
CHAPTER 10-INVENTORIES
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.
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.
The term “merchandise inventory” is generally applied to goods held by a trading
concern.
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
Finished goods are 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 goods and which can be traced directly to the
end product of the production process.
Factory or manufacturing supplies are similar to raw materials but their relationship
to the end product is indirect.
Factory of 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.
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?
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
e. Goods in the hands of salesmen or agents
f. Goods held by customers on approval or on trial
Exception to the legal test

Installment contracts may provide for retention of title by the seller until the selling
price is fully collected.
Following the legal test, 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 accepted 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, the goods sold on installment are included in the inventory of the buyer and
excluded from that of the seller, the legal test to the contrary notwithstanding.
This is a clear example of economic substance prevailing legal form.
This will depend on the terms, whether FOB destination or FOB shipping point. FOB
means free on board.
Under FOB destination, ownership of goods purchased is transferred only upon
receipt of the goods by the buyer at the point of destination.
Thus, under FOB destination, the goods in transit are still the property of the seller.
Accordingly, the seller shall legally be responsible for freight charges and other
expenses up to the point of destination.
On the other hand, if the term is FOB shipping point, ownership is transferred upon
shipment of the goods and therefore, the goods in transit are the property of the
buyer.
Accordingly, the buyer shall legally be 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 normalcy records purchases
when goods are received and sales when goods are shipped, regardless of the
precise moment at which title passed.
This procedure is expedient and no material misstatements occur in the financial
statements because title usually passes in the same accounting period.
However, the accountant should carefully analyze the invoice terms of goods that
are in transit at the end of the accounting period to determine who has legal title.
Accordingly, adjustments are in order if errors are committed in recording purchases
and sales.
Freight collect-This means that the freight charge on the goods 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 the buyer.
Freight prepaid- This means that the freight charge on the goods shipped is already
paid by the seller.
The terms “FOB destination" and "FOB shipping point" determine ownership of the
goods in transit and the party who is supposed to pay the freight charge and other
expenses from the point of shipment to the point of destination.
The terms “freight collect" and “freight prepaid" determine the party who actually paid
the freight charge but not the party who is supposed to legally pay the freight charge.
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 - Under this shipping contract, the buyer agrees
to pay in a lump sum the cost or 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 all expenses and risk of loss
until the goods are unloaded at which time title and risk of loss shall pass to the
buyer.
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 out on consignment are part of the cost
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.
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.
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.
Under the perpetual system, the cost of merchandise sold is immediately recorded
because this is clearly determinable from the stock card.
As a rule, the ending merchandise inventory is not adjusted. The balance of the
merchandise inventory account represents the ending inventory.
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 average.
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 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.
Methods of recording purchases

1. Gross method - Purchases and accounts payable are recorded at gross.
2. Net method - Purchases and accounts payable are recorded at net.
The cost measured under the net method represents the cash equivalent price on
the date of payment and therefore the theoretically correct historical cost.
However, in practice, most entities record purchases at gross invoice amount.
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.
Moreover, this procedure does not allocate discounts taken between goods sold and
goods on hand.
Despite its theoretical shortcomings, the gross method is supported on practical
grounds.
The gross method is more convenient than the net method from a bookkeeping
standpoint.
Moreover, if applied consistently over time, it usually produces no material errors in
the financial statements.
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
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 expense over the period of financing.
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.
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.
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.
By-products are measured at net realizable value and this value is deducted from the
cost of the main product.
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
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.
MULTIPLE CHOICE 10-26

1. Which of the following should not be taken into account when determining the cost
of inventory?
a. Storage costs of part-finished goods
b. Trade discounts
c. Recoverable purchase taxes
d. Import duties on shipping of inventory inward
2. The cost of inventory does not include

a. Salaries of factory staff
b. Storage cost necessary in the production process before a further production
stage
c. Abnormal amount of wasted materials
d. Irrecoverable purchase taxes
3. Which of the following costs of conversion cannot be included in cost of inventory?

a. Cost of direct labor
b. Factory rent and utilities
c. Salaries of sales staff.
d. Factory overhead based on normal capacity
4. Which of the following should be taken into account when determining the cost of
inventory?
a. Storage cost of part-finished goods
b. Abnormal freight in
c. Recoverable purchase tax
d. Interest on inventory loan
5. Costs incurred in bringing the inventory to the present location and condition
include
a. Cost of designing product for specific customers
b. Abnormal amount of wasted material
c. Storage cost not necessary in the production process before a further production
stage
d. Distribution cost
6. Inventories encompass all of the following, except

a. Merchandise purchased by a retailer
b. Land and other property not held for sale
c. Finished goods produced
d. Materials and supplies for use in production
7. A property developer must classify properties that it holds for sale in the ordinary
course of business as
a. Inventory
b. Property, plant and equipment
c. Financial asset
d. Investment property
8. Factory supplies to be consumed in the production process are reported as

a. Inventory
b. Property, plant and equipment
c. Investment property
d. Prepaid expenses
9. Which of the following should not be reported as inventory?

a. Land acquired for resale by a real estate firm
b. Shares and bonds held for resale by a brokerage firm
c. Partially completed goods held by a manufacturing entity
d. Machinery acquired by a manufacturing entity
10. When determining the cost of an inventory, which of the following should not be
included?
a. Interest on loan obtained to purchase the inventory
b. Commission paid when inventory is purchased
c. Labor cost of the inventory when manufactured
d. Depreciation of plant equipment used in manufacturing
10-27
1. Why is inventory included in the computation of net income
a. To determine cost of goods sold
b. To determine sales revenue
c. To determine merchandise returns
d. Inventory is not included in the computation of net income
2. Which of the following is a characteristic of a perpetual inventory system?

a. Inventory purchases are debited to a purchases account.
b. Inventory records are not kept for every item.
c. Cost of goods sold is recorded with each sale.
d. Cost of goods sold is determined as the amount of purchases less the change in
inventory.
3. Which of the following is incorrect about the perpetual inventory method?

a. Purchases are recorded as debit to the inventory account.
b. The entry to record a sale includes a debit to cost of goods sold and a credit to
inventory.
c. After a physical inventory count, inventory is credited for any missing inventory.
d. Purchase returns are recorded by debiting accounts payable and crediting
purchase returns and allowances.
4. An entry debiting inventory and crediting cost of goods sold would be made when
a. Merchandise is sold and the periodic inventory method is used.
b. Merchandise is sold and the perpetual inventory method is used..
c. Merchandise is returned and the perpetual inventory method is used.
d. Merchandise is returned and the periodic inventory method is used.
CHAPTER 11-INVENTORY COST FLOW

PAS 2, paragraph 25, expressly provides that the cost of inventories shall be
determined by using either:
a. First in, First out
b. Weighted average
The standard does not permit anymore the use of the last in, first out (LIFO) as an
alternative formula in measuring cost of inventories.
First in, First out (FIFO)
The FIFO method assumes that “the goods first purchased are first sold" and
consequently the goods remaining in the inventory at the end of the period are those
most recently purchased or produced.
In other words, the FIFO is in accordance with the ordinary merchandising procedure
that the goods are sold in the order they are purchased.
The rule is “first come, first sold".
The inventory is thus expressed in terms of recent or new prices while the cost of
goods sold is representative of earlier or old prices.
This method favors the statement of financial position in that the inventory is stated
at current replacement cost.
The objection to the method is that there is improper matching of cost against
revenue because the goods sold are stated at earlier or older prices resulting in
understatement of cost of sales.
Accordingly, in a period of inflation or rising prices, the FIFO method would result to
the highest net income.
However, in a period of deflation or declining prices, the FIFO method would result to
the lowest net income.
Weighted average - Periodic

The cost of the beginning inventory plus the total cost of purchases during the period
is divided by the total units purchased plus those in the beginning inventory to get a
weighted average unit cost.
Such weighted average unit cost is then multiplied by the units on hand to derive the
inventory value.
In other words, the average unit cost is computed by dividing the total cost of goods
available for sale by the total number of units available for sale.
Weighted average – Perpetual

When used in conjunction with the perpetual system, the weighted average method
is popularly known as the moving average method.
PAS 2, paragraph 27, provides that the weighted average may be calculated on a
periodic basis or as each additional shipment is received depending upon the
circumstances of the entity.
Under this method, a new weighted average unit cost must be computed after every
purchase and purchase return.
Thus, the total cost of goods available after every purchase and purchase return is
divided by the total units available for sale at this time to get a new weighted average
unit cost.
Such new weighted average unit cost is then multiplied by the units on hand to get
the inventory cost.
This method requires the keeping of inventory stock card in order to monitor the
“moving" unit cost after every purchase.
Cost of goods sold from the stock card

The argument for the weighted average method is that it is relatively easy to apply,
especially with computers. Moreover the weighted average method produces
inventory valuation that approximates current value if there is a rapid turnover of
inventory.
The argument against the weighted average method is that there may be a
considerable lag between the current cost and inventory valuation since the average
unit cost involves early purchases.
Last in, First out (LIFO)
The LIFO method assumes that “the goods last purchased are first sold" and
consequently the goods remaining in the inventory at the end of the period are those
first purchased or produced.
The inventory is thus expressed in terms of earlier or old prices and the cost of
goods sold is representative of recent or new prices.
The LIFO favors the income statement because there is matching of current cost
against current revenue, the cost of goods sold being expressed in terms of current
or recent cost.
The objection of the LIFO is that the inventory is stated at earlier or older prices and
therefore there may be a significant lag between inventory valuation and current
replacement cost.
Moreover, the use of LIFO permits income manipulation, such as by making year-
end purchases designed to preserve existing inventory layers. At times these
purchases may not even be in the best economic interest of the entity.
Actually, in a period of rising prices, the LIFO method would result to the lowest net
income. In a period of declining prices, the LIFO method would result to the highest
net income.
Note well that LIFO-periodic and LIFO-perpetual differ in inventory value.

Observe that the moving average unit cost changes every time there is a new
purchase or a purchase return. The moving average unit cost is not affected
by a sale or a sale return.
Specific identification means that specific costs are attributed to identified items of
inventory.
The cost of the inventory is determined by simply multiplying the units on hand by
their actual unit cost.
This requires records which will clearly determine the actual costs of goods on hand.
PAS 2, paragraph 23, provides that this method is appropriate for inventories that
are segregated for a specific project and inventories that are not ordinarily
interchangeable.
The specific identification method may be used in either periodic or perpetual
inventory system.
The major argument for this method is that the flow of the inventory cost corresponds
with the actual physical flow of goods.
With specific identification, there is an actual determination of cost of units sold and
on hand.
The major argument against this method is that it is very costly to implement even
with high-speed computers. Specific identification means that specific costs are
attributed to identified items of inventory.
The cost of the inventory is determined by simply multiplying the units on hand by
their actual unit cost.
This requires records which will clearly determine the actual costs of goods on hand.
PAS 2, paragraph 23, provides that this method is appropriate for inventories that
are segregated for a specific project and inventories that are not ordinarily
interchangeable.
The specific identification method may be used in either periodic or perpetual
inventory system.
The major argument for this method is that the flow of the inventory cost corresponds
with the actual physical flow of goods.
With specific identification, there is an actual determination of cost of units sold and
on hand.
The major argument against this method is that it is very costly to implement even
with high-speed computers.
Standard costs are predetermined product costs established on the basis of normal
levels of materials and supplies, labor, efficiency and capacity utilization.
Observe that a standard cost is predetermined and, once determined, is applied to
all inventory movements - inventories, goods available for sale, purchases and
goods sold or placed in production.
PAS 2, paragraph 21, states that the standard cost method may be used for
convenience if the results approximate cost.
However, the standards set should be realistically attainable and are reviewed and
revised regularly in the light of current conditions.
Standard costing is taken up in a higher accounting course and is not discussed
further in this book.
Relative sales price method
When different commodities are purchased at a lump sum, the single cost is
apportioned among the commodities based on their respective sales price. This is
based on the philosophy that cost is proportionate to selling price.
MULTIPLE CHOICE
1. IFRS prohibits which cost flow assumption?
a. LIFO
b. Specific identification
c. Weighted average
d. Any of these cost flow assumptions is allowed
2. What is the inventory pricing procedure in which the oldest costs rarely have an
effect on the ending inventory?
a. FIFO
b. LIFOO
c. Specific identification
d. Weighted average
3. In a period of falling prices which inventory method generally provides the lowest
amount of ending inventory?
a. Weighted average
b. FIFO
c. Moving average
d. Specific identification
4. Which inventory cost flow assumption would consistently result in the highest
income in a period of inflation?
a. FIFO
b. LIFO
c. Weighted average
5. The costing of inventory must be deferred until the end of reporting period under
which of the following method of inventory valuation?
a. Moving average
b. Weighted average
c. LIFO perpetual
d. FIFO perpetual
6. Cost of goods sold is the same under periodic system and perpetual system using
a. FIFO
b. LIFO
c. Weighted average
7. The cost of inventories that are not ordinarily interchangeable and goods
produced and segregated for specific projects shall be measured using
a. FIFO
b. Average method
c. LIFO
8. Which is the reason why the specific identification method may be considered
ideal for assigning cost to inventory and cost of goods sold?
a. The potential for manipulation of net income is reduced.
b. There is no arbitrary allocation of cost.
c. The cost flow matches the physical flow.
d. It is applicable to all types of inventory.
9. IFRS requires the specific identification method in certain circumstances. Which of

the following is likely to be a circumstance where the specific identification method
can be used?
a. Unit price is low.
b. Inventory turnover is low.
c. Inventory quantities are large.
d. All of the choices are likely circumstances.
10. Which cost flow assumption is used for inventory when an entity builds
townhouses?
a. FIFO
b. Specific identification
c. Weighted average
d. Any of these cost flow assumptions
CHAPTER 12-LOWER OF COST AND NET REALIZABLE VALUE

Measurement of inventory
PAS 2, paragraph 9, provides that inventories shall be measured at the lower of cost
and net realizable value.
The measurement of inventory at the lower of cost and net realizable value is now
known as LCNRV.
Net realizable value or NRV is the estimated selling price in the ordinary course of
business less the estimated cost of completion and the estimated cost of disposal.
The cost of inventories may not be recoverable under the following circumstances:
a. The inventories are damaged.
b. The inventories have become wholly or partially obsolete.
c. The selling prices have declined.
d. The estimated cost of completion or the estimated cost of disposal has increased.
The practice of writing inventories down below cost to net realizable value is
consistent with the view that assets shall not be carried in excess of amounts
expected to be realized from their sale or use.
Determination of net realizable value
Inventories are usually written down to net realizable value on an item by item or
individual basis.
It is not appropriate to write down inventories based on a classification of inventory,
for example, finished goods or all inventories in a particular industry or geographical
segment.
In some circumstances, however, it may be appropriate to group similar or related
items.
This may be the case with items of inventory relating to the same product line that
have similar purposes, are produced and marketed in the same geographical area
and cannot be practically evaluated separately.
Materials held for use in production are not written down below cost if the finished
products in which they will be incorporated are expected to be sold at or above cost.
However, when a decline in the price of materials indicates that the cost of the
finished products exceeds net realizable value, the materials are written down to net
realizable value.
In such circumstances, the replacement cost of materials may be the best evidence
of net realizable value.
Accounting for inventory writedown

If the cost is lower than net realizable value, there is no accounting problem because
the inventory is measured at cost and the increase in value is not recognized.
If the net realizable value is lower than cost, the inventory is measured at net
realizable value and the decrease in value is recognized.
Methods of accounting for the inventory writedown

a. Direct method or cost of goods sold method
b. Allowance method or loss method
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 writedown or gain on reversal of inventory writedown 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 writedown is accounted
for separately.
This method is also known as “loss method" because a loss account “loss on
inventory writedown" is debited and a valuation account “allowance for inventory
writedown" is credited.
In subsequent years, this allowance account is adjusted upward or downward
depending on the difference between the cost and net realizable value of the
inventory at year-end.
If the required allowance increases, an additional loss is recognized.
If the required allowance decreases, a gain on reversal of inventory writedown is
recorded.
However, the gain is limited only to the extent of the allowance balance.
Preferably, the allowance method is used in order that the effect’s of writedown and
reversal of writedown can be clearly identified.
As a matter of fact, PAS 2, paragraph 36, requires disclosure of the amount of any
inventory writedown and the amount of any reversal of inventory writedown.
The inventory is measured at the lower of cost and net realizable applied on an item
by item or individual basis.
The entry will have the effect of increasing cost of goods sold because the NRV is
lower than cost.
The loss on inventory writedown is accounted for separately.
The loss on inventory writedown is included in the computation of cost of goods sold.
The allowance for inventory writedown is presented as a deduction from the
inventory.
The decrease in allowance is a reversal of the previous inventory writedown and
recorder as gain on reversal of writedown.
The gain on reversal of inventory writedown is presented as a deduction from cost of

goods sold.
PAS 2, paragraph 34, provides that the amount of any reversal of any writedown of
inventory arising from an increase in net realizable value shall be recognized as a
reduction in the amount of inventory recognized as an expense in the period in which
the reversal occurs.
The amount of inventory recognized as an expense of the period is actually the cost
of goods sold during the period.
Note that whether direct method or allowance method, the cost of goods sold
must be the same.
Purchase commitments are obligations of the entity to acquire certain goods

sometime in the future at a fixed price and fixed quantity.
Actually, a purchase contract has already been made for future delivery of goods
fixed in price and in quantity.
Where the purchase commitments are significant or unusual, disclosure is required
in the accompanying notes to financial statements.
Any losses which are expected to arise from firm and noncancelable commitments
shall be recognized.
If there is a decline in purchase price after a purchase commitment has been made,
a loss is recorded in the period of the price decline.
Note that a purchase commitment must be noncancelable in order that a loss
purchase commitment can be recognized.
Thus, if at the end of the reporting period, the purchase price falls below the agreed
price the difference is accounted for as a debit to loss on purchase commitments and
a credit to an estimated liability.
The loss on purchase commitment is classified as other expense and the estimated
liability for purchase commitment is classified as current liability.
LCNRV Adaptation
Actually, the recognition of a loss on purchase commitment is an adaptation of the
measurement at the lower of cost or net realizable value.
Accordingly, if the market price rises by the time the entity makes the purchase, a
gain on purchase commitment would be recorded.
However, the amount of gain to be recognized is limited to the loss on purchase
commitment previously recorded.
The gain on purchase commitment is classified as other income.
Disclosures
With respect to inventories, the financial statements shall disclose the following:
a. The accounting policies adopted in measuring inventories, including the cost
formula used.
b. The total carrying amount of inventories and the carrying amount in classifications
appropriate to the entity.
Common classifications of inventories are merchandise, production supplies, goods
in process and finished goods.
c. The carrying amount of inventories carried at fair value less cost of disposal.
d. The amount of inventories recognized as an expense during the period.
e. The amount of any writedown of inventories recognized as an expense during the
period.
f. The amount of reversal of writedown that is recognized as income.
g. The circumstances or events that led to reversal of a writedown of inventories.
h. The carrying amount of inventories pledged as security for liabilities.
Agricultural, forest and mineral products
PAS 2, paragraph 4, provides that inventories of agricultural forest and mineral
products are measured at net realizable value at certain stages of production.
Accordingly, agricultural crops that have been harvested or mineral products that
have been extracted are measured at net realizable value:
a. When a sale is assured under a forward contract or government guarantee.
b. When a homogeneous market exists and there is a negligible risk of failure to sell.
Commodities of broker-traders
PAS 2, paragraph 3, provides that commodities of broker-traders are measured at
fair value less cost of disposal
PFRS 13, paragraph 9, defines fair value of an asset as the price that would be
received to sell the asset in an orderly transaction between market
participants.
Broker-traders are those who buy and sell commodities for others or on their own
account.
The inventories of broker-traders are principally acquired with the purpose of selling
them in the near future and generating a profit from fluctuations in price or broker-
traders' margin.
MULTIPLE CHOICE
1. Net realizable value is
a. Current replacement cost
b. Estimated selling price
c. Expected selling price less expected cost to complete and cost of disposal
d. Estimated selling price less estimated cost to complete and cost of disposal
2. Inventories are usually written down to net realizable value

a. Item by item
b. By classification
c. By total
d. By segment
3. LCNRV is best described as the

a. Reporting of a loss when there is a decrease in the future utility below the original
cost.
b. Method of determining cost of goods sold.
c. Assumption to determine inventory flow.
d. Change in inventory value to net realizable value.
4. LCNRV of inventory
a. Is always either the net realizable value or cost.
b. Must be equal to net realizable value.
c. May sometimes be less than net realizable value.
d. Must be equal to estimated selling price less cost to complete and cost of
disposal.
5. Which statement is true regarding inventory writedown and reversal of writedown?

a. Reversal of inventory writedown is prohibited.
b. Separate reporting of reversal of inventory writedown is required.
c. An entity is required to record an inventory
writedown in a separate loss account.
d. All of the choices are correct.
CHAPTER 13-GROSS PROFIT METHOD

Use of estimate in inventory valuation
In many cases, it is necessary to know the approximate value of inventory when it is
not possible to take a physical count.
Even if the physical count is possible, the same may prove costly, difficult or
inconvenient at the moment.
There are two widely accepted procedures for approximating the value of inventory,
namely the gross profit method and the retail inventory method.
The approximation or estimation of inventory is made for varied reasons.
The most common reasons for making an estimate of the cost of the goods on hand
are:
a. The inventory is destroyed by fire and other catastrophe, or theft of the
merchandise has occurred and the amount of
Inventory is required for insurance purposes.
b. A physical count of the goods on hand is made and it is necessary to prove
the correctness or reasonableness of such count by making an estimate.
This is known as the “gross profit test” in the accounting parlance.
c. Interim financial statements are prepared and a physical count of the goods
on hand is not necessary because it may take time to do the same.
Moreover, only an estimate is required to fairly present the financial position and
financial performance of the entity for interim reporting purposes.
GROSS PROFIT METHOD

The gross profit method is based on the assumption that the rate of gross profit
remains approximately the same from period to period and therefore the ratio of cost
of goods sold to net sales is relatively constant from period to period.
Cost of goods sold
The gross profit method is so called because the cost of goods sold is computed
through the use of the gross profit rate.
The cost of goods sold is computed as follows:
a. Net sales multiplied by cost ratio
This formula is used when the gross profit rate is based on sales.
b. Net sales divided by sales ratio
This formula is used when the gross profit rate based on cost.
The cost of goods sold is computed by multiplying the net sales by the cost ratio.
The cost of goods sold is computed by dividing the net sales by the sales ratio.
As exemplified earlier, the gross profit rate is expressed as a percent of sales or as a
percent of cost of goods sold.
The gross profit rate on sales is the common way of quoting gross margin because
goods are stated on a sale price basis, rather than on a cost basis.
Besides, the gross profit rate on sales is naturally lower than that based on cost and
this lower rate creates a favorable impression on the part of the customers.
The ending inventory is computed under each of the following assumptions:

a. Gross profit rate is 25% on sales
b. Gross profit rate is 25% on cost
Note that in computing “net sales”, the sales allowance and sales discount are
disregarded.
Sales allowance and sales discount

Sales allowance and sales discount are ignored, that is, not deducted from sales.
The reason is that while these items decrease the amount of sales, they do not affect
the physical volume of goods sold.
Sales allowance and sales discount do not increase the physical inventory of goods,
unlike in sales return where there is an
actual addition to goods on hand.
To deduct sales allowance and sales discount from sales would result to
overstatement of inventory with a consequent understatement of cost of goods sold
and overstatement of gross income
Why overstate inventory when there is no addition to physical inventory created by
sales allowance and sales discount?
Note that the inventory computed, where sales allowance and sales discount are
considered, is higher than that where the same items are disregarded.
Where the account is “sales return and allowance" with no details, the same should
be deducted from sales.
In sales allowance, there is no physical transfer of goods from the customer
but a mere reduction in the sales price.
MULTIPLE CHOICE
1. The gross profit method assumes that
a. The amount of gross profit is the same as in prior years.
b. Sales and cost of goods sold did not change.
c. lnventory values have not increased.
d. The relationship between selling price and cost of goods sold is similar in prior
years.
2. The gross profit method is not valid when

a. There is substantial increase in the quantity of inventory .
b. There is substantial increase in the cost of inventory.
c. The gross margin percentage changes significantly.
d. All ending inventory is destroyed by fire
3. Which statement is not valid about the gross profit method?

a. It may be used by auditors.
b. It is an acceptable accounting procedure.
c. It may be used for interim statements.
d. It may be used for annual statements.
4. Which is nota basic assumption of the gross profit method?

a. The beginning inventory plus net purchases equals total goods to be accounted
for.
b. Goods not sold must be on hand.
c. The sales reduced to cost basis when deducted from the sum of beginning
inventory and net purchases would result to inventory on hand.
d. The amount of purchases and the amount of sales remain relatively unchanged
from the previous period.
5. How is the gross profit method used in relation to inventory?

a. To verify the accuracy of the perpetual inventory record
b. To verify the accuracy of the physical inventory
c. To estimate the cost of goods sold
d. To provide a FIFO inventory value
CHAPTER 14-RETAIL INVENTORY METHOD

The retail inventory method is the other method of estimating the value of inventory.
PAS 2, paragraph 22, provides that this method is often used in the retail industry for
measuring inventory of large number of rapidly changing items with similar margin
for which it is impracticable to use other costing method.
In other words, the retail inventory method is generally employed by department
stores, supermarkets and other retail concerns where there is a wide variety of
goods.
This is so because keeping track of unit cost at all times is difficult.
The retail inventory method came to its name because the selling price or retail price
is tagged to each item.
The term “retail" simply means selling price.
Information required
The use of the retail inventory method requires that records be kept which must
show the following data:
a. Beginning inventory at cost and at retail price
b. Purchases during the period at cost and at retail price
c. Adjustments to the original retail price such as additional markup, markup
cancelation, markdown and markdown cancelation
d. Other adjustments such as departmental transfer, breakage, shrinkage, theft,
damaged goods and employee discount
Basic formula
In principle and procedure wise, the formula for the retail inventory method is very
similar to the gross profit method.
The difference is that under the gross profit method, the ending inventory is stated at
cost while under the retail inventory method, the ending inventory is expressed in
terms of selling price.
By reason of the computation of the cost ratio, it is necessary that the goods
available for sale should be determined not only in terms of selling price but also in
terms of cost.
Treatment of items
a. Purchase discount - deducted from purchases at cost only.
b. Purchase return-deducted from purchases at cost and at retail.
c. Purchase allowance- deducted from purchases at cost only.
d. Freight in - addition to purchases at cost only.
e. Departmental transfer in or debit- addition to purchases at cost and at retail.
f. Departmental transfer out or credit-deduction from purchases at cost and retail.
g. Sales discount and sales allowance-disregarded, meaning, not deducted from
sales.
h. Sales return - deducted from sales.
If the account is “sales return and allowance", the same should be deducted from
sales.
i. Employee discounts - added to sales.
Employee discounts are special discounts usually not recorded because they are
directly deducted from the sales price.
Only the net sales price is recorded. Consequently, the amount of sales is
understated. Thus, the employee discounts are added back to sales.
j. Normal shortage, shrinkage, spoilage, breakage-This is deducted from goods
available for sale at retail.
Any normal shortage is usually absorbed or included in cost of goods sold.
k. Abnormal shortage, shrinkage, spoilage, breakage-This is deducted from goods
available for sale at both cost and retail so as not to distort the cost ratio. Any
abnormal amount is reported separately as loss.
Items related to retail method
Accordingly, in the determination of the inventory at retail and for purposes of
computing the cost ratio, the following items should be considered:
The original sales price is frequently raised or lowered particularly at the end of the
selling season where replacement costs are changing.
a. Initial markup - original markup on the cost of goods.
b. Original retail - the sales price at which the goods are first offered for sale.
c. Additional markup - increase in sales price above the original sales price.
d. Markup cancelation -- decrease in sales price that does not decrease the sales
price below the original sales price.
e. Net additional markup or net markup - markup minus markup cancelation.
f. Markdown - decrease in sales price below the original sales price.
g. Markdown cancelation - increase in sales price that does not increase the sales
price above the original sales price.
h. Net markdown - markdown minus markdown cancelation.
i. Maintained markup - difference between cost and sales price after adjustment for
all of the above items. Sometimes, maintained markup is referred to as “markon".
Approaches in the use of retail method

To obtain the appropriate inventory value under the retail inventory method, three
approaches are followed, namely:
a. Conservative or conventional or lower of cost and net realizable value approach
b. Average cost approach
c. FIFO approach
The conservative approach includes net markup and excludes net markdown in
determining the cost ratio in order to arrive conservative cost.
Notice that the conservative cost is lower than the average cost. Thus, this approach
is also known as the lower of average cost or market.
On the other hand, the average cost approach includes both net markup and net
markdown in determining cost ratio.
The reason for such an approach is to arrive at an inventory that will approximate or
equal historical cost.
PAS 2, paragraph 22, provides that the percentage used under the retail method
shall take into consideration inventory that has been marked down to below the
original selling price.
An average percentage for each retail department is often used.
This means that the average cost approach shall be applied in conjunction with the
retail inventory method.
FIFO retail approach
The FIFO retail approach is similar to the average cost approach in that it considers
both net markup and net markdown in computing the cost ratio.
However, a current cost ratio is determined every year considering the net
purchases during the year and excluding the beginning inventory.
The FIFO approach is based on the assumption that markup and markdown apply to
goods purchased during the year and not to beginning inventory.
MULTIPLE CHOICE
1. An advantage of the retail inventory method is that it
a. Permits entities to avoid taking an annual physical inventory.
b. Yields a more accurate measurement of inventory.
c. Hides costs from customers and employees.
d. Provides a method for inventory control and facilitates determination of the
periodic inventory.
2. To produce an inventory valuation which approximates the lower of cost and NRV
using the retail method, the computation of the ratio of cost to retail should
a. Include markup but not markdown
b. Include markup and markdown
c. Ignore both markup and markdown
d. Include markdown but not markup
3. When the conventional retail inventory method is used, markdowns are commonly
ignored in the computation of cost to retail ratio because
a. There may be no markdowns during the year.
b. This tends to give a better approximation of the lower of average cost and net
realizable value.
c. Markups are also ignored.
d. This tends to result in the showing of a normal profit margin in a period when no
markdown goods have been sold.
4. The retail inventory method would include which of the following in the calculation
of the goods available for sale at both cost and retail?
a. Freight in
b. Purchase return
c. Markup
d. Markdown
5. With regard to the retail inventory method, which is the most accurate statement?
a. Generally, accountants ignore net markups and net markdowns in computing the
cost ratio.
b. Generally, accountants exclude net markups and include net markdowns in
computing cost ratio.
c. The retail method results in a lower ending inventory if net markups are included
but net markdowns are excluded in computing the cost ratio.
d. It is not adaptable to FIFO costing.
6. The conventional retail method produces an ending inventory that approximates

a. Lower of average cost and net realizable value
b. Lower of FIFO cost and net realizable value
c. Lower of LIFO cost añd net realizable value
d. Lower of cost and net realizable value
7. If the conservative retail inventory method is used, which of the following

calculations would include or exclude net markdowns?
Cost ratio Ending inventory at retail

a. Include Include
b. Include Exclude
c. Exclude Include
d. Exclude Exclude
8. Which of the following is not a reason why the retail inventory method is used
widely?
a. As a control measure in determining inventory shortage
b. For insurance information
c. To permit the computation of net income without a physical count of inventory
d. To defer income tax liability
CHAPTER 15-FINANCIAL ASSET AT FAIR VALUE

Definition of investments
The International Accounting Standards Board defines investments as follows:
Investments are assets held by an entity for the accretion of wealth through
distribution such as interest, royalties, dividends and rentals, for capital appreciation
or for other benefits to the investing entity such as those obtained through trading
relationships.
Actually, investments are assets not directly identified with the operating activities of
an entity and occupy only an auxiliary relationship to the central revenue producing
activities of the entity.
Purposes of investments
Investments are held for diverse reasons such as:
a. For accretion of wealth or regular income through interest, dividends, royalties and
rentals.
b. For capital appreciation as in the case of investments in land and real estate held
for appreciation and direct investments in gold, diamonds and other precious
commodities.
c. For ownership control as in the case of investments in subsidiaries and

associates.
d. For meeting business requirements as in the case of sinking fund, preference
share redemption fund, plant expansion fund and other noncurrent fund.
e. For protection as in the case of interest in life insurance contract in the form of
cash surrender value.
Examples of investments
Specifically, investments include the following:
1. Trading securities or financial asset at fair value through profit or loss
2. Financial asset at fair value through other comprehensive income
3. Investment in nontrading equity securities
4. Investment in bonds or financial asset at amortized cost
5. Investment in associate
6. Investment in subsidiary
7. Investment property
8. Investment in fund
9. Investment in joint venture
Statement classification
Investments are classified either as current or noncurrent assets.
Current investments are investments that are by their very nature readily realizable
and are intended to be held for not more than one year.
For example, trading securities are normally classified as current assets because
these investments are expected to be realized within twelve months after the end of
reporting period.
Noncurrent or long-term investments are investments other than current
investments.
This residual definition means that the noncurrent investments are intended to be
held for more than one year or are not expected to be realized within twelve months
after the end of the reporting period.
Definition of financial asset

A financial asset is any asset that is:
a. Cash
b. A contractual right to receive cash or another financial asset from another entity.
c. A contractual right to exchange financial instrument with another entity under
conditions that are potentially favorable.
d. An equity instrument of another entity.
Examples of financial assets

Cash or currency is a financial asset because it represents the medium of exchange
and is therefore the basis on which all transactions are measured and recognized in
financial statements.
A deposit of cash with a bank or similar financial institution is a financial asset

because it represents the contractual right of the depositor to obtain cash from the
bank or to draw a check against the balance in favor ofa creditor in payment of a
financial liability.
But a gold bullion deposited in bank is not a financial asset because although it is
very precious the gold is a commodity.
Financial assets representing a contractual right to receive cash in the future include
trade accounts receivable, notes receivable and loans receivable.
In case of exchanges of financial instruments with another entity, conditions are
potentially favorable when such exchanges will result to gain or additional cash
inflow to the entity.
An example of a favorable condition is an option held by the holder to purchase
shares of another entity at less than market price.
Investments in shares or other equity instruments such as trading securities can be
classified as financial assets.
Not considered financial assets

Intangible assets are not financial assets.
Physical assets, such as inventory and property, plant and equipment are not also
financial assets.
Control of such physical and intangible assets creates an opportunity to generate an

inflow of cash or another financial asset but it does not give rise to a present right to
receive cash or another financial asset.
Prepaid expenses for which the future economic benefit is the receipt of goods or
services rather than the right to receive cash or another financial asset are not also
financial assets.
Leased assets are not also financial assets because control of such assets does not
give rise to a present right to receive cash or another financial asset.
Classification of financial assets

Under PFRS 9, paragraph 4.1.1, financial assets are classified into three, namely:
1. Financial assets at fair value through profit or loss- include both equity securities
and debt securities.
2. Financial assets at fair value through other comprehensive income - include both
equity securities and debt securities.
3. Financial assets at amortized cost - include only debt securities.
The classification depends on the business model for managing financial assets
which may be:
a. To hold investments in order to realize fair value changes.
b. To hold investments in order to collect contractual cash flows.
c. To hold investments in order to collect contractual cash flows and sell the
investment.
What is an equity security?
The term “equity security" encompasses any instrument representing ownership
shares and right, warrants or options to acquire or dispose of ownership shares at a
fixed or determinable price.
In simple language, equity securities represent an ownership interest in an entity.
Ownership shares include ordinary shares, preference shares and rights or options
to acquire ownership shares.
The owners of equity securities are legally known as shareholders.
A share is the ownership interest or right of a shareholder in an entity. The share is
evidenced by an instrument called share certificate. This right pertains to the share in
earnings, election of directors, subscription for additional shares and share in net
assets upon liquidation
Equity securities do not include redeemable preference shares, treasury shares and
convertible debt.
What is a debt security?
A debt security is any security that represents a creditor relationship with an entity.
A debt security has a maturity date and a maturity value.
Examples of debt securities include the following:
a. Corporate bonds
b. BSP treasury bills
c. Government securities
d. Commercial papers
e. Preference shares with mandatory redemption date or are redeemable at the
option of the holder
Initial measurement of financial asset

PFRS 9, paragraph 5.1.1, provides that at inital recognition, an entity shall measure
a financial asset at fair value plus, in the case of financial asset not at fair value
through profit or loss, transaction costs that are directly attributable to the acquisition
of the financial asset.
The fair value of a financial asset at initial recognition is normally the transaction
price, meaning, the fair value of the consideration given.
In other words, a financial asset is recognized initially at fair value.
As a rule, transaction costs that are directly attributable to the acquisition of the
financial asset shall be capitalized as cost of the financial asset.
However, if the financial asset is held for trading or if the financial asset is measured
at fair value through profit or loss, transaction costs are expensed outright.
Transaction costs include fees and commissions paid to agents, advisers, brokers
and dealers, levies by regulatory agencies and securities exchanges, and transfer
taxes and duties.
Transaction costs do not include debt premiums or discounts, financing costs and
internal administrative or holding costs.
Subsequent measurement
PFRS 9, paragraph 5.2.1, provides that after initial recognition, an entity shall
measure a financial asset at:
a. Fair value through profit or loss (FVPL)
b. Fair value through other comprehensive income
c. Amortized cost
Financial assets at fair value through profit or loss

The following financial assets shall be measured at “fair value through profit or loss":
1. Financial assets held for trading or popularly known as “trading securities".
These financial assets are measured at fair value through profit or loss “by
requirement," meaning, required by the standard.
2. All other investments in quoted equity instruments.

These financial assets are measured at fair value through profit or loss “by
consequence" in accordance with Application Guidance B5.1.14 of PFRS 9.
3. Financial assets that are irrevocably designated on initial recognition as at fair

value through profit or loss.
These financial assets are measured at fair value through profit or loss, “by
irrevocable designation" or "by option".
This fair value option is applicable to investments in bonds and other debt
instruments which can be irrevocably designated as at fair value through profit or
loss even if the financial assets satisfy the amortized cost or fair value through other
comprehensive income measurement.
This irrevocable designation is the fair value option allowed in accordance with
Paragraph 4.1.5 of PFRS9
4. All debt investments that do not satisfy the requirements for measurement at
amortized cost and at fair value through other comprehensive income.
These financial assets are measured at fair value through profit or loss “by default" in
accordance with PFRS 9, paragraph 4.1.4.
Financial asset held for trading

Appendix A of PFRS 9 provides that a financial asset is held for trading if:
a. It is acquired principally for the purpose of selling or repurchasing it in the near
term.
b. On initial recognition, it is part of a portfolio of identified financial assets that are
managed together and for which there is evidence of a recent actual pattern of short-
term profit taking.
c. It is a derivative, except for a derivative that is a financial guarantee contract or a
designated and an effective hedging instrument.
In other words, trading securities are debt and equity securities that are purchased
with the intent of selling them in the “near term" or very soon.
Trading securities are normally classified as current assets.
Equity investment at fair value through OCI

At initial recognition, PFRS 9, paragraph 5.7.5, provides that an entity may make an
irrevocable election to present in other comprehensive income or OCI subsequent
changes in fair value of an investment in equity instrument that is not held for trading.
This irrevocable approach is designed to impose discipline in accounting for
nontrading equity investment.
The amount recognized in other comprehensive income is not reclassified to
profit or loss under any circumstances.
However, on derecognition, the amount may be transferred to equity or retained
earnings.
If the investment in equity instrument is “held for trading the election to present gain
and loss in other comprehensive income is not allowed.
lf the investment in equity instrument is held for trading subsequent changes in fair
value are always included in profit or loss.
Debt investment at amortized cost

PFRS 9, paragraph 4.1.2, provides that a financial asset shall measured at
amortized cost if both of the following conditions are met:
a. The business model is to hold the financial asset in order to collect contractual
cash flows on specified date.
b. The contractual cash flows are solely payments of principal and interest on the
principal amount outstanding.
In other words, the business model is to collect contractual cash flows if the
contractual cash flows are solely payments of principal and interest.
In such a case, the financial asset shall be measured at amortized cost.
Debt investment at fair value through OCI

PFRS 9, paragraph 4.1.2A, provides that a financial asset shall be measured at fair
value through other comprehensi1ve income if both of the following conditions are
met:
a. The business model is achieved both by collecting contractual cash flows and by
selling the financial asset.
b. The contractual cash flows are solely payments of principal and interest on the
principal outstanding.
Note that the business model includes selling the financial asset in addition to
collecting contractual cash flows.
In this case, interest income is recognized using the effective interest method as in
amortized cost measurement.
On derecognition, the cumulative gain and loss recognized in other comprehensive
income shall be reclassified to profit or loss.
The measurement of debt investment at amortized cost or fair value through other
comprehensive income is discussed extensively in Chapter 20.
SUMMARY OF MEASUREMENT RULES
Measurement of equity investments
1. Held for trading - at fair value through profit or loss
2. Not held for trading - as a rule, at fair value through profit or loss
3. Not held for trading - at fair value through other comprehensive income by
irrevocable election
4. All other investments in quoted equity instruments -at fair value through profit or
loss
5. Investments in unquoted equity instruments - at cost
6. Investments of 20% to 50%-equity method of accounting
7. Investments of more than 50% - consolidation method to be taken up in an
advanced accounting course.
Measurement of debt investments

1. Held for trading - at fair value through profit or loss
2. Held for collection of contractual cash flows-at amortized cost
3. Held for collection of contractual cash flows-at fair value through profit or loss by
irrevocable designation or fair value option
4. Held for collection of contractual cash flows and for sale of the financial asset-at
fair value through other comprehensive income
5. Held for collection of contractual cash flows and for sale of the financial asset-at
fair value through profit or loss by irrevocable designation or fair value option
Fair value
Appendix A of PFRS 9 in conjunction with PFRS 13 provides a new definition of fair
value.
Fair value of an asset is the price that would be received to sell an asset in an
orderly transaction between market participants at the measurement date.
The best evidence of fair value in descending hierarchy is the quoted price of
identical asset in an active market, the quoted price of similar asset in an active
market and the quoted price of identical and similar asset in an inactive market.
An active market is a market in which transactions take place with sufficient
regularity and volume to provide pricing information on an ongoing basis.
Simply stated, fair value is the price agreed upon by a buyer and a seller in an arm's
length or orderly transaction.
The buyer and seller who are the market participants must be independent,
knowledgeable and willing, meaning not forced or not compelled to enter into the
transaction.
Quoted price
Most often, the fair value of securities is the quoted price in the securities market, for
example, the Philippine Stock Exchange.
If the quoted price pertains to a share or equity security, it means pesos per share.
For example, if the investment in 10,000 shares of an entity costing P800,000 is
quoted at 90, the market value thereof is P900,000, computed by multiplying 10,000
shares by P90 per share.
If the quoted price pertains to a bond or debt security, it means percent of the face
amount of the bond.
For example, if the investment in bond with face amount of P2,000,000 costing
P1,700,000 is quoted at 90, the market value is P1,800,000, computed by multiplying
the face amount of P2,000,000 by 90%.
Gain and loss - Financial asset at fair value

Under PFRS 9, paragraph 5.7.1, gain and loss on financial asset measured at fair
value shall be presented in profit or loss, except:
a. When the financial asset is an investment in nontrading equity instrument and the
entity has irrevocably elected to present unrealized gain and loss in other
comprehensive income
b. When the financial asset is a debt investment that is measured at fair value
through other comprehensive income.
In other words, unrealized gain and loss on financial asset held for trading and other
financial asset measured at fair value are reported in the income statement.
Unrealized gain and loss arise from investments that are reported at fair value.
In determining fair value, no deduction is made for transaction costs that may be
incurred on disposal of the financial asset.
If the fair value is higher than carrying amount, the difference is an unrealized gain.
If the fair value is lower than carrying amount, the difference is an unrealized loss.
Gain and loss that result from actually selling the investments are known as realized
gain and realized loss.
Gain and loss - Financial asset at amortized cost

Unrealized gain and loss on financial asset at amortized cost are not recognized
simply because such investments are not reported at fair value.
PFRS 9, paragraph 5,7.2, provides that gain and loss financial asset measured at
amortized recognized in profit or loss when the financial asset is derecognized, sold,
impaired or reclassified, and through amortization process.
FVPL means that the financial asset is measured at fair value through profit or loss.
The unrealized gain is classified in the income statement as other income.
The unrealized loss is reported in the income statement as other expense.
PFRS 9, paragraph 3.2.12, provides that on derecognition of financial asset the
difference between the carrying amount and the consideration received shall be
recognized in profit or loss.
In other words, on disposal of a trading investment, the difference between the cash
received and the carrying amount is recognized as gain or loss on disposal to be
reported in the income statement.
Observe that the unrealized gain and unrealized loss are offset against the other and
only the net amount is recorded. This offsettings permitted by the standard.
However, the notes to financial statements shall disclose the individual securities
with their corresponding carrying amount and market value
The difference between the sale price and the carrying amount shall be recognized
as gain or loss to be reported in the income statement.
Equity investment at fair value through OCI
As stated earlier, at initial recognition, an entity may make an irrevocable election to
present in other comprehensive income subsequent changes in value of an
investment in nontrading equity instrument.
The equity securities do not qualify as financial asset held for trading. The entity
made an irrevocable election to present unrealized gain and loss in other
comprehensive income.
FVOCI means the financial asset is measured at fair value through other
comprehensive income.
Under PFRS 9, paragraph 5.1.1, a financial asset measured at fair value through
other comprehensive income shall be recognized intially at fair value plus transaction
cost directly attributable to the acquisition.
The financial asset FVOCI - is normally classified as noncurrent asset.
Gain or loss on disposal of equity investment measured at fair value through other
comprehensive income is recognized in retained earnings in accordance with PFRS
9, paragraph 5.7.1b.
Moreover, the cumulative gain or loss previously recognized in other comprehensive
income is also transferred to retained earnings in accordance with PFRS 9
Application Guidance, paragraph 5.7.1.
The amount recognized in other comprehensive income is not reclassified to

profit or loss under any circumstances.
Impairment - Equity investments at fair value
For financial assets measured at fair value, all gains and losses are either presented
in profit or loss or in other comprehensive income depending on whether the election
to present gains and losses on equity investments in other comprehensive income is
taken or not.
Therefore, it is not necessary to assess financial assets measured at fair value

through profit or loss and equity investments measured at fair value through other
comprehensive income for impairment.
Impairment - Debt investments
PFRS 9, paragraph 5.5.1, provides that an entity shall recognize expected credit loss
on:
a. Debt investment measured at amortized cost
b. Debt investment measured at fair value through other comprehensive income
Paragraph 5.5.3 provides that an entity shall measure the loss allowance for a
financial instrument at an amount equal to the lifetime expected credit loss if the
credit risk on that financial instrument has increased significantly since initial
recognition.
Credit loss is the present value of all cash shortfalls.
Expected credit loss is an estimate of credit loss over the life of the financial
instrument.
The amount of impairment loss can be measured as the difference between the
carrying amount and the present value of estimated future cash flows discounted at
the original effective rate.
MULTIPLE CHOICE
15-16
1. Depending on the business model for managing financial assets, an entity shall
classify financial assets subsequent to initial recognition at
a. Fair value through profit or loss
b. Amortized cost
c. Fair value through other comprehensive income
d. All of these are used in measuring financial assets
2. A debt investment is measured at amortized cost

a. By irrevocable election
b. When the debt investment is managed and evaluated on a document risk-
management strategy.
c. When the debt investment is held for trading.
d. When the business model is to collect contractual cash flows that are solely
payments of principal and interest.
3. The irrevocable election to present changes in fair value in other comprehensive

income is applicable only to
a. Investment in equity instrument not held for trading.
b. Investment in equity instrument held for trading.
c. Financial asset measured at amortized cost.
d. Financial asset measured at fair value.
4. A debt investment shall be measured at fair value through other comprehensive

income
a. When the debt investment is held for trading.
b. When the debt investment is not held for trading.
c. By irrevocable designation
d. When the business model is to collect contractual cash flows and also to sell the
financial asset
5. Which is not a category of financial assets?

a. Financial assets at fair value through profit or loss
b. Financial assets at fair value through other comprehensive income
c. Financial assets at amortized cost
d. Financial assets held for sale
15-17
1. Under IFRS, the presumption is that equity investments are
a. Held for trading
b. Held to profit from price changes
c. Held for trading and held to profit from price changes
d. Held as financial assets at fair value through other comprehensive income
2. Entities are required to measure financial asset based on all of the following,
except
a. The business model for managing financial asset.
b. Whether the financial asset is a debt or an equity investment.
c. The contractual cash flow characteristics of the financial asset.

d. All of the choices are correct.
3. Debt investments that meet the business model and contractual cash flow tests
are reported at
a. Net realizable value
b. Fair value
c. Amortized cost
d. The lower of amortized cost and fair value
4. Debt investments not held for collection are reported at

a. Amortized cost
b. Fair value
c. The lower of amortized cost and fair value
d. Net realizable value
5. Debt investments at amortized cost are

a. Managed and evaluated based on a documented risk management strategy
b. Trading debt investments
c. Held for collection debt investments
d. All of these are correct

CHAPTER 9-15 Intermediate Accounting

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CHAPTER 9-15 Intermediate Accounting

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INTERMEDIATE ACCOUNTING VOLUME 1

CHAPTER 9-RECEIBVABLE FINANCING (Discounting of note receivable)

Terms related to discounting of note

 Maturity value which is equal to the principal plus interest.

 There is no objection if the interest expense is “netted” against the interest

 Premises considered, it is believed that the discounting of note receivable with

2. The note receivable discounted account is reported as

3. If a note receivable is discounted without recourse

4. Note receivable discounted with recourse should be

Exception to the legal test

A consignment is a method of marketing goods in which the owner called the

Methods of recording purchases

Variable production overhead is allocated to each unit of production on the basis of

MULTIPLE CHOICE 10-26

2. The cost of inventory does not include

3. Which of the following costs of conversion cannot be included in cost of inventory?

6. Inventories encompass all of the following, except

8. Factory supplies to be consumed in the production process are reported as

9. Which of the following should not be reported as inventory?

2. Which of the following is a characteristic of a perpetual inventory system?

3. Which of the following is incorrect about the perpetual inventory method?

CHAPTER 11-INVENTORY COST FLOW

Weighted average - Periodic

Weighted average – Perpetual

Cost of goods sold from the stock card

Note well that LIFO-periodic and LIFO-perpetual differ in inventory value.

9. IFRS requires the specific identification method in certain circumstances. Which of

CHAPTER 12-LOWER OF COST AND NET REALIZABLE VALUE

Accounting for inventory writedown

Methods of accounting for the inventory writedown

The gain on reversal of inventory writedown is presented as a deduction from cost of

Purchase commitments are obligations of the entity to acquire certain goods

2. Inventories are usually written down to net realizable value

3. LCNRV is best described as the

5. Which statement is true regarding inventory writedown and reversal of writedown?

CHAPTER 13-GROSS PROFIT METHOD

GROSS PROFIT METHOD

The ending inventory is computed under each of the following assumptions:

Sales allowance and sales discount

2. The gross profit method is not valid when

3. Which statement is not valid about the gross profit method?

4. Which is nota basic assumption of the gross profit method?

5. How is the gross profit method used in relation to inventory?

CHAPTER 14-RETAIL INVENTORY METHOD

Approaches in the use of retail method

6. The conventional retail method produces an ending inventory that approximates

7. If the conservative retail inventory method is used, which of the following

Cost ratio Ending inventory at retail

CHAPTER 15-FINANCIAL ASSET AT FAIR VALUE

c. For ownership control as in the case of investments in subsidiaries and

Definition of financial asset

Examples of financial assets

A deposit of cash with a bank or similar financial institution is a financial asset

Not considered financial assets

Control of such physical and intangible assets creates an opportunity to generate an

Classification of financial assets

Initial measurement of financial asset

Financial assets at fair value through profit or loss

2. All other investments in quoted equity instruments.

3. Financial assets that are irrevocably designated on initial recognition as at fair

Financial asset held for trading

Equity investment at fair value through OCI

Debt investment at amortized cost