FINANCIAL ACCOUNTING & REPORTING 1

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Inventories

Module 017 Accounting for Inventories

In this topic, Inventories, you will learn about the following:

8.1 Definition, nature, and classes of inventories
8.2 Recognition
8.3 Initial measurement at cost

At the end of this module, you will be able to:

1. define inventories;
2. state the objectives of accounting for inventories;
3. enumerate and differentiate the items making up the inventories of
merchandising, manufacturing, and service entities;
4. identify the costs included in inventories

8.1 Definition, nature, and classes of inventories

The accounting treatment of inventories is governed by PAS 2, Inventories. As its number
suggests, the Standard on inventory is one of the oldest standards produced, originally
issued in 1975. Since then, limited amendments have been issued concerning this Standard.
Inventories are defined as assets that are:
a. held for sale in the ordinary course of business
b. in the process of production for such sale
c. in the form of materials or supplies to be consumed in the production
process or in the rendering of services
The nature of the business determines the designation of an item as inventory.
Inventories encompass goods purchased and held for resale, including, for example,
merchandise purchased by a retailer and held for resale or land and other property held for
resale. Inventories also encompass finished goods produced, or work in progress being
produced, by the entity and include materials and supplies awaiting use in the production
process. In the case of a service provider, inventories include the costs of the service, as
described in paragraph 19, for which the entity has not yet recognized the related revenue.
PAS 2’s exclusions are fairly limited and relate mostly to particular industries.
PAS 2 does not apply to:
•Work in progress arising under construction contracts, including directly related
service contracts. This type of inventory is covered by PAS 11 and will be discussed
later in this course.
•Financial instruments. These are covered by PAS 32 Financial Instruments:
Presentation and PAS 39 Financial Instruments: Recognition and Measurement.
•Biological assets. Biological assets related to agricultural activity and agricultural
produce at the point of harvest are addressed by PAS 41 Agriculture

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 PAS 2 also excludes certain other inventories from its measurement rules, although it
includes them for the other requirements of the Standard. These exemptions relate to
inventories that, in accordance with accepted practices in particular industries, are
"marked to market." In other words, all movements in their value (both up and down)
while the inventories are held are taken straight to profit or loss, even though they are not
realized by a sale. These inventories referred to in paragraph 3(a) of PAS 2 are measured at
the net realizable value at certain stages of production. The detailed conditions that apply
for these types of excluded inventories are discussed in paragraphs 3-5 of PAS 2.
Examples include:
• Agricultural and forest products
• Agricultural produce after harvest
Also, commodities held by commodity brokers/traders are excluded from pAS 2 in certain
circumstances. Broker traders buy or sell commodities for others or on their own account.
These inventories are generally acquired with the purpose of selling in the near future and
generating a profit from price fluctuations or broker traders' margins. They are excluded
from the measurement requirements of PAS 2 when they are measured at fair value (which
is the amount for which an asset could be exchanged, or a liability settled, between
knowledgeable, willing parties in an arm's length transaction) with fewer costs to sell. The
changes in this value are recognized in profit or loss in the period of change.

Examples of commodities typically held by traders include:

• Oil
• Natural gas
• Gold
• Coffee
• Wheat

8.2 Recognition
The basic criterion for including items in inventory is economic control rather than
physical possession. For an inventory, economic control is usually consistent with legal
ownership.
As a rule, all goods to which the entity has a legal title shall be included in the inventory,
regardless of the location.
Normally, all goods are recorded in inventory when received by the purchaser and
recorded as sold by the seller when shipped. When the financial statements are prepared,
however, all goods under the economic control of the enterprise should be included in
inventory whether or not the company has physical or legal possession of these goods.
Examples of goods are in transit purchased at Free on Board (FOB) Shipping point, goods in
transit sold at FOB Destination, goods with buyback arrangements, goods under financing
arrangements, etc.
However, installment contracts may provide retention of title by the seller until the selling
price is fully paid. Following the above legal test, the goods sold on an installment basis are
still the property of the seller and therefore normally included in the seller's inventory.
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Goods In transit
Normally, some inventories are in transit to the company or its customers at the
reporting date. When goods are in transit at the end of the accounting period,
the terms of shipment determine whether the seller or the buyer includes
them in its inventory. If the goods are shipped FOB shipping point, legal title to
(and economic control of) the goods passes with the loading of goods at the point of
shipment. The buyer should include these goods in its inventory, and a
corresponding liability is recognized.
If the goods are shipped FOB destination, legal title (and control) is not transferred
until the goods are delivered to the buyer’s destination. Physical receipt of the goods
by the buyer normally determines when it should record the inventory in its
accounting system.
Legal ownership in transit also determines the risk of loss for goods damaged or lost
during shipment.
Consigned Goods
Goods may be transferred from one party to another for the purposes of sale
without the ownership and ultimate economic control changing hands. The
company delivering the goods, called the consignor, retains ownership, while the
entity receiving the goods, called the consignee, attempts to sell them. If the goods
are sold, the consignee earns a commission and remits the net amount to the
consignor; whereas if the goods are not sold, they are returned to the consignor.
The goods must be included in the inventory of the consignor at cost, plus the
handling and shipping costs incurred in the delivery of the goods to the
consignee. The consignee, acting as an agent, does not own the goods; hence,
neither consigned goods nor obligation for such goods is reported in its financial
statements.
Segregated gods
Special order goods manufactured according to customer specifications, even if still
in possession of the selling company, should be considered as sold when completed
and therefore excluded from the selling company's inventory. The rationale for this
matter is that the manufacturer undertakes and completes the processing of the
goods based on the order and specifications of the customers. Thus, at the point of
completion, revenues are considered to have been earned.
However, if the goods are customarily manufactured (i.e., goods are considered
stock items of the company), they should be considered as part of ending inventory
even if such goods are already segregated and actually ready for pick up by the
customer.

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 Conditional Sales and Installment Sales
Despite the retention of title by the seller under the installment contract, the
substance of the transaction is that control over the goods has already passed to the
buyer. The goods are recorded as sold when delivered and, therefore, excluded
from the inventory of the seller.
Since the seller anticipates completion of the contract and the ultimate passing of
title, it recognizes the transaction as a regular sale and removes the goods from
reported inventory at the time of sale. On the other hand, when the buyer intends to
comply with the contract and acquire title, it recognizes the transaction as a regular
purchase.

8.3 Initial measurement at cost

In accordance with par. 9, inventories shall be measured at the lower cost and net
realizable value.
The cost of inventories shall comprise all costs of purchase, costs of conversion, and other
costs incurred in bringing the inventories to their present location and condition.
Cost of Purchase
The costs of purchase include:
• Purchase price (+)
• Any import duties and other non-recoverable taxes (+)
• Transport, handling, and other costs directly attributable to the acquisition of
the inventory (+)
• Any trade discounts, rebates, and other similar items (–)
PAS 2 mentions the case where an entity buys inventory on deferred credit terms.
Where the price paid is higher than it would have been under normal credit terms,
the excess is not included in the cost of the inventory but is recognized as an interest
expense over the period of the financing.
PAS 2 does not permit exchange differences arising directly from the recent
acquisition of inventories invoiced in a foreign currency to be included in the cost of
the inventories.
For example, a supplier may pay its customer an upfront cash incentive when
entering into a contract. This is a form of a rebate, and the incentive should be
accounted for as a liability by the customer until it receives the related inventory,
which is then shown at the cost net of this incentive.
Cost of Conversion
Costs of conversion are a complex aspect of inventory measurement and may
require the use of a sophisticated costing system to record the various inputs.
The costs of conversion of inventories include costs directly related to the units of
production, such as direct labor. They also include a systematic allocation of fixed
and variable production overheads that are incurred in converting materials into
finished goods.
It must be remembered that the inclusion of overheads is not optional. Overheads
may comprise indirect labor and materials or other indirect costs of production. For
the most part, there are few problems over the inclusion of direct costs in
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inventories, although difficulties may arise over the inclusion of certain types of
overheads and over the allocation of overheads into the inventory valuation.
Overhead costs must be apportioned using a 'systematic allocation of fixed and
variable production overheads that are incurred in converting materials into
finished goods. Overheads should be allocated to the cost of inventory on a
consistent basis from year to year and should not be omitted in anticipation of a net
realizable value problem.
Variable production overheads are defined as those indirect costs of production
that vary directly, or nearly directly, with the volume of production, such as indirect
materials and indirect labor, which are allocated to each unit of production based on
the actual use of the production facilities.
Costs of conversion also include a systematic allocation of fixed production
overhead based on normal production capacity. Normal capacity is the production
expected to be achieved on average over a number of periods or seasons under
normal circumstances, taking into account the loss of capacity resulting from
planned maintenance. The actual level of production may be used if it approximates
normal capacity.
Examples of costs excluded from the cost of inventories and recognized as expenses
in the period in which they are incurred are:
(a) abnormal amounts of wasted materials, labor, or other production costs;
(b) storage costs, unless those costs are necessary for the production process
before a further production stage;
(c) administrative overheads that do not contribute to bringing inventories to
their present location and condition; and
(d) selling costs.
The effect of this approach is that the amount of overheads allocated to each
unit of production is not increased as a consequence of low-capacity or idle
plant, and as a result, unallocated overheads are expensed in the period in
which they are incurred. (This happens automatically because they are not
added to inventory.)
Conversely, if there is abnormally high production in excess of normal
capacity, it is necessary to reduce the rate of overhead absorption in order to
avoid carrying the inventory at more than the actual cost. Where actual
production for the period is close to normal capacity, it can be used as the
basis for the allocation of fixed overheads.
Storage and distribution costs
Storage costs are not permitted as part of the cost of inventory unless they
are necessary for the production process. [PAS 2.16(b)]. This appears to
prohibit including the costs of the warehouse and the overheads of a retail
outlet as part of the inventory, as neither of these is a prelude to a further
production stage.

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Where it is necessary to store raw materials or work in progress prior to a
further processing or manufacturing stage, the costs of such storage should
be included in production overheads. For example, it would appear
reasonable to allow the costs of storing maturing stocks, such as cheese,
wine, or whisky, in the cost of production.
Although distribution costs are obviously a cost of bringing an item to its
present location, the question arises as to whether costs of transporting
inventory from one location to another are eligible.
Costs of distribution to the customer are not allowed as they are selling costs,
which are prohibited by the Standard from being included in the carrying
value of inventory. It, therefore, seems probable that distribution costs of
inventory whose production process is complete should not normally be
included in its carrying value. If the inventory is transferred from one of the
entity's storage facilities to another and the condition of the inventory is not
changed at either location, none of the warehousing costs may be included in
inventory costs. It follows that transportation costs between the two storage
facilities should not be included in the carrying value of inventory.
A question arises about the meaning of 'production' in the context of large
retailers, for example, supermarkets. As the transport and logistics involved
are essential to their ability to put goods on sale at a particular location in an
appropriate condition, it seems reasonable to conclude that such costs are an
essential part of the production process and can be included in the cost of
inventory. The circumstances of the entity may warrant the inclusion of
distribution or other costs into the cost of sales even though they have been
excluded from the cost of inventory.
General and administrative overheads
PAS 2 specifically disallows administrative overheads that do not contribute
to bringing inventories to their present location and condition. [PAS 2.16c].
Other costs and overheads that do contribute are allowable as costs of
production. There is a judgment to be made about such matters, as on a very
wide interpretation, any department could be considered to make a
contribution. For example, the accounts department will normally support
the following functions:
(a) production – by paying direct and indirect production wages and
salaries, controlling purchases and related payments, and preparing periodic
financial statements for the production units;
(b) marketing and distribution – by analyzing sales and by controlling the
sales ledger; and
(c) general administration – by preparing management accounts and annual
financial statements and budgets, controlling cash resources, and by planning
investments.
Only those costs of the accounts department that can be allocated to the
production function can be included in the cost of conversion. Part of the
management and overhead costs of a large retailer's logistical department
may be included in the cost if it can be related to bringing the inventory to its
present location and condition. These types of costs are unlikely to be
material in the context of the inventory total held by organizations. An entity
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wishing to include a material amount of overhead of a borderline nature

must ensure it can sensibly justify its inclusion under the provisions of PAS 2
by presenting an analysis of the function and its contribution to the
production process similar to the above.
Where joint products are produced, and their costs of conversion are not
separately identifiable, costs of conversion are allocated between them on a rational
and consistent basis. For example, a wood factory produces timber and, as a spillage,
it generates saw dust that is processed into energy pellets to be used for heating.
The allocation of conversion costs between joint products requires some rational
basis, such as the relative sales value of the products at the time of separation (this
can be either at a certain stage in the production process or at the completion of the
production). Where one product is of minor significance compared to the other(s), it
is regarded as a by-product rather than a joint product, and it is common to measure
it at net realizable value, which has the effect of attributing all the profit to sales of
the main product(s).
PAS 2 emphasizes that the inventories of service providers (essentially their work
in progress) should include only direct labor costs, other direct costs, and
attributable overheads. Non-attributable overheads and profit margins should not
be included, but the costs of supervisory personnel are included.
Other Costs
Other costs are included in the cost of inventories only to the extent that they are
incurred in bringing the inventories to their present location and condition. For
example, it may be appropriate to include non-production overheads or the costs of
designing products for specific customers in the cost of inventories if they
contribute to bringing the inventories to their present condition and location.
To begin with, under certain circumstances, one category might be borrowing costs
under PAS 23 Borrowing Costs. PAS 23 requires capitalizing interest on inventories
which take a substantial amount of time to create. However, an entity is not
required to capitalize borrowing costs for inventories that are manufactured in
large quantities on a repetitive basis. An entity may purchase inventories on
deferred settlement terms. When the arrangement effectively contains a financing
element, that element -- for example, the difference between the purchase price for
normal credit terms and the amount paid -- is recognized as interest over the period
of the financing.
Products that require a maturation process also provide an example of when it may
be appropriate to include storage costs in the inventory. Normally, storage costs are
excluded because they are not costs of bringing the inventory to its current location
and condition, but the condition of a maturing product continues to change during
its period of storage, so this is an appropriate exception.
Techniques for the measurement of the cost of inventories, such as the standard cost
method or the retail method, may be used for convenience if the results approximate cost.
Standard costs take into account normal levels of materials and supplies, labor, efficiency,

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

Net Realizable Value

Net realizable value refers to the net amount that an entity expects to realize from
the sale of inventory in the ordinary course of business.
Net realizable value is the estimated selling price in the ordinary course of business,
less the estimated costs of completion and the estimated costs necessary to make
the sale.
Fair value is the amount for which an asset could be exchanged, or a liability settled,
between knowledgeable, willing parties in an arm's length transaction.
In accordance with PAS 41, Agriculture inventories comprising agricultural produce
that an entity has harvested from its biological assets are measured on initial
recognition at their fair value fewer costs to selling at the point of harvest. This is
the cost of the inventories at that date for the application of this Standard.
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Glossary
Cash Discount: an incentive for early payment of amounts owing on credit transactions,
normally quoted as a percentage
Consigned Goods: inventory that is physically located at a dealer but whose ownership is
retained by the shipper until the dealer sells the inventory
Inventories: assets held for sale in the ordinary course of business, in the process of
production for such sale, and in the form of materials or supplies to be consumed in the
production process or in the rendering of services.
Net realizable value: the estimated selling price in the ordinary course of business less the
estimated costs of completion and the estimated costs necessary to make the sale.
Fair value: the price that would be received to sell an asset or paid to transfer a liability in
an orderly transaction between market participants at the measurement date.
Finished goods: manufactured products for which the manufacturing process is complete
FOB Destination: terms of sale under which title of goods passes to the purchaser at the
point of destination
FOB shipping point: terms of sale under which title of goods passes to the purchaser at
the point of shipment
Work in progress: partially completed products that require further process or work
before they can be sold.
Raw materials: inventory acquired by a manufacturer for use in the production process.
Trade discount: a reduction in the list price of an item which is the amount actually
charged to the customer; generally, trade discounts are dependent on the volume of
business or size of order from the customer.

References and Supplementary Materials

Books and Journals
1. PAS 2, Inventories
2. Robles, N. S., & Empleo, P. M. (2014). Intermediate Accounting (2014 ed., Vol. 1). Manila,
Philippines.
3. Valix, C. T., Peralta, J. F., & Valix, C. M. (2017). Financial Accounting (2017 ed., Vol.
2).Manila, Philippines.

Online Supplementary Reading Materials

1. Inventory Accounting Guidelines;
https://www.dfa.cornell.edu/accounting/topics/inventories; 21 October 2017
2. Inventories for Supply and Resale; http://www.fa.ufl.edu/directives-and-
procedures/inventories-for-supply-and-resale/; 21 October 2017

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 3. 8.1 Determining and Reporting the Cost of Inventory;
http://open.lib.umn.edu/financialaccounting/chapter/8-1-determining-and-
reporting-the-cost-of-inventory/; 21 October 2017
4. IAS 2 Inventories; http://www.ifrs.org/issued-standards/list-of-standards/ias-2-
inventories/; 21 October 2017
5. Types/classification of inventory;
http://www.accountingformanagement.org/classification-of-inventory/; 21 October
2017

Online Instructional Videos

1. Chapter 8: How Does a Company Gather Information about its inventory;
http://app.wistia.com/embed/medias/e2105b22a3; 21 October 2017
2. Accounting - Inventory, and Cost of Goods Sold;
https://www.youtube.com/watch/MeRusrAouA4 ; 21 October 2017
3. IAS 2 Inventories; https://www.youtube.com/watch/6kY8mj8WxNY; 21 October
2017
4. ACCA P2 Inventory (IAS 2); https://www.youtube.com/watch/iTnVu4AkroI; 21
October 2017
5. Inventory Basics - Whiteboard Wednesday;
https://www.youtube.com/watch/n71eTqT1ne8; 21 October 2017
6. Intermediate Accounting I: Inventories I;
https://www.youtube.com/watch?v=NKDYZOE9JdM; 21 October 2017