FINANCIAL ACCOUNTING & REPORTING 1

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Inventories

Module 020 Accounting for Inventories

Have you ever heard of the Goldilocks principle? It has its foundations in the
children's story of Goldilocks and the three bears. In the story, the bears'
preferences are stuck at either extreme (too hot or too cold porridge, too
hard or too soft beds, etc.) And it's always the middle that is always 'just right
for Goldilocks. Basically, the Goldilocks principle dictates that the ideal
should always fall between certain extremes - basically getting everything
'just right. And getting everything 'just right is exactly what inventory
management is all about. Good inventory management is all about having the
right amount of product, at the right price, at the right time, and in the right
place.

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

8.8 Other Inventory Issues (Purchase commitment, Relative sales price
method, and Inventory errors)
8.9 Financial statement presentation and disclosures
8.10 Internal control and management of inventory

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

1. Analyze the effects of inventory errors on current and future financial
statements

2. Identify the information relating to inventories required to be disclosed

in the financial statements.

8.8 Other Inventory Issues

Purchase commitment
Companies often contract with suppliers to purchase a specified quantity of
materials during a future period at an agreed unit cost. This is usually done to lock
in prices and ensure sufficient quantities. Purchase commitments may be subject to
revision or cancellation before the end of the contract period. Other purchase
commitments, however, are non-cancelable and are not subject to revision.
Disclosure in the notes to the financial statement is required for a purchase contract
subject to revision or cancellation if:
(1) a future loss is possible;
(2) the amount of the commitment can be reasonably estimated; and

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 (3) the amount is material. The note disclosure gives the relevant aspects of the
contingency. No entry is required for purchase contracts subject to revision
and cancellation.
When purchase contracts are non-cancelable, and when a loss is probable and
material and can be reasonably estimated, the loss and related liability should be
recorded in the accounts.
To illustrate, assume that on October 1, 2016, ABC entered into a non-cancelable
commitment to purchase six months after the date, 100,000 (1.00 x 100,000 units)
is recorded on December 31, 2016, as:
Loss on Purchase Commitments 100,000
Estimated Liability on Purchase Commitments 100,000

When the actual purchase was made on April 1, 2017, the cost of the inventory item
decreased further to P8.50 per unit. The purchase is recorded as:
Purchases 850,000
Loss on Purchase Commitments 50,000

Estimated Liability on Purchase Commitments 100,000

Accounts Payable 1,000,000

The loss is thus assigned to the period in which the decline takes place. It is reported
on SCOI as income among the operating expenses, while the estimated liability on
purchase commitments is reported on the statement of financial position as a
current liability.
When there is a full or partial recovery of the purchase price, the recovery would be
recognized as a gain in the period during which the recovery takes place. Thus, if the
inventory cost on April 1, 2017, is P9.25 per unit, the purchase entry would be as
follows:
Purchases 925,000
Estimated Liability on Purchase Commitments 100,000
Accounts Payable 1,000,000
Recovery of Loss on Purchase Commitments 25,000
Recovery of loss on purchase commitments is reported on the Statement of
Comprehensive Income as other operating income. The amount of recovery that is
taken up, however, is limited to the loss recorded in the previous period for the
same purchase commitment.
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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 the selling price.
For instance, products A, B, and C are purchased at a "basket price" of P3, 000, 000.
Assume that the said products have the following sales price: A, P500, 000;
B, P1, 500, 000; and C, P3, 000, 000.
The cost of each product is computed as follows:
Product A 500,000 5/50 × 3,000,000 300,000
Product B 1,500,000 15/50 × 3,000,000 900,000
Product C 3,000,000 30/50 × 3,000,000 1,800,000
Total 5,000,000 3,000,000

Effects of inventory errors

Errors in the measurement of the inventory and the recording of purchases can
result in inaccurate figures on the statement of financial position and statement of
comprehensive income. The effects of some common errors (assuming a periodic
inventory system and disregarding income taxes) are summarized as follows:
A. A purchase on credit is omitted from both purchases account and ending
inventory. The purchase is recorded only when the goods are received in the
succeeding year.
1. Statement of Comprehensive Income
Current year- Profit is correct. Purchases are understated, understanding the costs
of goods sold: however, ending inventory is understated, overstating the cost of
goods sold. The errors in the purchases and in the ending inventory offset each
other.
Succeeding year- Income is correct. Purchases are overstated, overstating the cost
of goods sold; however, beginning inventory is understated, understanding the cost
of goods sold. The errors in purchases and in beginning inventory offset each other.
2. Statement of Financial Position
Current year- Ending inventory and accounts payable are both understated.
Succeeding year- No error exists anymore in the statement of financial position.

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 B. A purchase on credit is omitted from the Philippines account, but the
ending inventory is correct. Purchases are recorded in the succeeding year.
1. Statement of Comprehensive Income
Current year- Profit is overstated because purchases are understated and,
therefore, the cost of goods sold is understated.
Succeeding year- Profit is understated because purchases are overstated and,
therefore, the cost of goods sold is overstated.
2. Statement of Financial Position
Current year- Accounts payable are understated because a purchase has been
omitted. The balance of retained earnings is overstated because profit is overstated.
Succeeding year- No error exists anymore in the statement of financial position.
The overstatement in profit of the previous year is counterbalanced by the
understatement in profit for this year.

C. Ending inventory is over (under) stated due to quantity and/or costing

errors, but purchases are correct.
1. Statement of Comprehensive Income
Current year- Profit is over (under) stated because the cost of goods sold is under
over (under) stated.
Succeeding year- Profit is under (over) stated because beginning inventory is over
(under) stated, and therefore cost of goods sold is over (under) stated.
2. Statement of Financial Position
Current year- Ending inventory and retained earnings are over (under) stated.
Succeeding year- All balances are correct because the errors in inventory and
retained earnings in the previous year were counterbalanced in this year.

8.9 Financial Statement presentation and disclosures

Disclosure requirements
In measuring inventories, there are a number of disclosure requirements with
which an entity must comply, such as:
1. The financial statements shall disclose the accounting policies adopted in
measuring inventories, including the cost formula used.
2. The financial statements shall disclose the total carrying amount of
inventories, analyzed into appropriate categories.
For a manufacturing entity such as our group, appropriate categories for the
classification of inventories could be:
● Raw materials
● Production supplies and merchandise
● Work in progress
● Finished goods
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However, each entity should determine what is relevant to its own business.
3. The number of inventories recognized as an expense in the period. To achieve
this, the cost of sales needs to be disclosed.
4. The amount of any write-down of inventories recognized as an expense in the
period, the amount of any reversal of any write-down that is recognized as a
reduction in the amount of inventories recognized as an expense in the period, and
the circumstances or events that led to the reversal of a write-down of inventories.
In either of these situations, we assume that the entity can easily determine (1)
exactly what inventory has been written down to net realizable value, and (2) at the
next balance sheet date, which of the items that were previously written down are
still held and are now stated at a higher amount. However, it may not always be
possible to do this in practice.
5. The carrying amount of inventories pledged as security for liabilities if any.
6. The carrying amount of inventories carried at fair value fewer costs to sell.
But this applies only to certain agricultural products and commodities, as referred
to in paragraphs 3–5 of PAS 2.

To see a disclosure example from Good Group, refer below. Please note that this
example does not include the disclosures with respect to the requirements of
paragraph 36(d-h) of PAS 2.
Accounting policy
Inventories
Inventories are valued at a lower cost and net realizable value.
Costs incurred in bringing each product to its present location and condition are
accounted for as follows:
Raw materials – purchase cost on a first in, first out basis.
Finished goods and work in progress – cost of direct materials and labor and a
proportion of manufacturing overheads based on normal operating capacity but
excluding borrowing costs.
Cost of inventories includes the transfer from the equity of gains and losses on
qualifying cash flow hedges in respect of the purchases of raw materials.
Net realizable value is the estimated selling price in the ordinary course of
business, the less estimated cost of completion, and the estimated cost necessary
to make the sale.

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 Notes on inventories

2016 2015
Raw materials (at cost) 6,046 7,793

Work in progress (at cost) 13,899 11,224

Finished goods (at cost or net realizable value) 4,930 6,472

Total inventories at a lower cost and net realizable
24,875 25,489
value

8.10 Internal control and management of inventory

Inventories are assets that become the major source of a company's revenue. Thus, internal
control procedures must be adopted by an entity to safeguard inventories and to ensure
that there is reliable information on inventories.
Internal control procedures on inventories focus on the following:
a. Physical inspection and counting of all items of inventories received by the entity from
suppliers to immediately remediate the discrepancy between delivery and purchase
order;
b. Keeping inventories in a warehouse that restricts access to unauthorized persons;
c. Monitoring movements of inventories, from receiving department to the stockroom, to
the production department, to the finished goods warehouse, to the shipping
department, etc.;
d. Appropriate storage of inventories by classification, using inventory tags so that
inventory requirements are served without undue delay;
e. Monitoring inventory quantities to minimize losses due to stockouts and losses from
obsolescence;
f. Conducting a periodic obsolete inventory review;
g. Periodic reconciliation of stock cards inventory and physical inventory;
h. Checking the bill of materials, which is a record of parts used to construct a product;
and
i. Creating a procedure to track scrap transactions.
Inventory management is the practice of overseeing and controlling the ordering, storage,
and use of components that a company uses in the production of the items it sells.
Inventory management is also the practice of overseeing and controlling quantities of
finished products for sale. A business's inventory is one of its major assets and represents
an investment that is tied up until the item sells.
Businesses incur costs to store, track and insure inventory. Inventories that are
mismanaged can create significant financial problems for a business, whether the
mismanagement results in an inventory glut or an inventory shortage.
Successful inventory management involves creating a purchasing plan to ensure that items
are available when they are needed — but that neither too much nor too little is purchased
— and keeping track of existing inventory and its use. Two common inventory-
management strategies are the just-in-time (JIT) method, where companies plan to
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receive items as they are needed rather than maintaining high inventory levels, and
materials requirement planning (MRP), which schedules material deliveries based on
sales forecasts.
• Balancing the JIT Method
Companies can save significant amounts of money and reduce waste by using a JIT
inventory management system. JIT means that manufacturers and retailers keep
only what they need to produce and sell products in inventory, which reduces
storage and insurance costs, as well as the cost of liquidating or discarding unused,
unwanted inventory. To balance this style of inventory management, manufacturers
and retailers must work together to monitor the availability of resources on the
manufacturer's end and consumer demand on the retailer's. Otherwise, JIT
inventory management can be risky. For example, a furniture retailer keeps no more
than four mahogany dining room chairs in stock. The retailer displays the chairs in
its showroom; no additional chairs are stored in the back room. A manufacturer
orders no more than the amount of mahogany needed from its source to produce
those four chairs. During the retailer's peak season, when customers special order
24 chairs, the manufacturer acquires the exact amount of mahogany needed to
manufacture and ship 24 chairs. If the manufacturer cannot acquire the mahogany it
needs from its source, however, the retailer runs the risk of not being able to fill the
customers' special orders for both the manufacturer and retailer; being out of stock
results in lost revenue and diminished reputation.
• Balancing the MRP Method
The MRP inventory management method is the sales-forecast defendant. This
means that manufacturers must have accurate sales records to enable accurate
planning of inventory needs and to communicate those needs with materials
suppliers in a timely manner. For example, a ski manufacturer using an MRP
inventory system might ensure that materials such as plastic, fiberglass, wood, and
aluminum are in stock based on forecasted orders. Inability to accurately forecast
sales and plan inventory acquisitions results in a manufacturer's inability to fulfill
orders.
In addition, getting everything 'just right is exactly what inventory management is
all about. Good inventory management is all about having the right amount of
product, at the right price, at the right time, and in the right place.
1. The right amount
Stocking the right amount is really important. If you order too little, your customers
will start looking elsewhere when you're out of stock of popular items. But if you
order too much, there's a chance you'll be stuck with lots of extra stock that you'll be
forced to sell at clearance prices or risk having them become obsolete.
2. The right price
Entities don’t want to be paying more for their products than they have to, but lower
prices aren’t always better. Suppliers often promise price quantity breaks - they just

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have to order 20% more stock to save 10% - and may find themselves digging into
their savings to make this purchase.
But is that the best choice for your business? After all, purchasing stock is only the
beginning. There's a whole host of carrying costs attached to your products. The
more stock you have on hand, the more you'll have to spend on storage facilities
while increasing your risk of having products going out of date.
If you’re wondering how to minimize these carrying costs while matching customer
demand as much as possible, that’s where the Economic Order Quantity (EOQ)
formula comes in.

3. The right time

Knowing your EOQ lets you know the inventory level you want to maintain, but how
do you decide when it's time to place a new order? Of course, you want your
shipment to arrive just in time… ideally when your previous batch is about to sell
out. If it arrives too early, you'll be looking for space to store these items. And if it
arrives too late, well, you'll be forced to announce that you're out of stock.
Opening backorders offers a way to deal with out-of-stock situations, but there’s a
chance your customers will prefer looking elsewhere to find the products that they
want. So you always want to make sure you’ve got stock on hand, which is where
your reorder point comes into play.
When it comes to calculating your reorder point, you need to take into account the
time it takes to get your items picked, packed, and shipped to you (lead time).
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4. The right place
Do you sell on multiple channels? If you do, ensuring you’ve got the right amount of
products in the right place is probably a challenge you face constantly.
The great thing about selling online is that you're fulfilling all orders from the same
pool of stock, so you don't have to think too much about how many items you want
to allocate to individual sales channels. But that can come with a whole different
host of problems: If your online inventory shows five items available, you want all
five ready for sale in your warehouse - not traveling the country in a mobile shop or
lying idle in your consignment store at the opposite end of the country. To prevent
situations like this from occurring, consider an inventory management system that
tracks inventory movement across all your sales channels in real-time. If you're
looking to reduce your risk of overselling, getting an inventory system that updates
your stock movements across all channels will get that down to zero.
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Glossary
Purchase commitment: a firm commitment to acquire goods or services from a supplier.
Relative sales price method: a technique used to allocate joint costs based on the prices
at which products will be sold
Inventory errors: over or under-statements in the inventory that may affect the
current and subsequent periods.
Just-in-time (JIT) method: an inventory strategy companies employ to increase efficiency
and decrease waste by receiving goods only as they are needed in the production process,
thereby reducing inventory costs.
Materials requirement planning: an integrated information system used by businesses.

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. Common errors when accounting for inventories – NZ IAS 2 – Part 1;
https://www.bdo.nz/en-nz/microsites/accounting-alert-october-2017/common-
errors-when-accounting-for-inventories-%E2%80%93-nz-ias-2-%E2%80%93-part-1;
21 October 2017
2. IAS 2 Inventories; http://www.ifrs.org/issued-standards/list-of-standards/ias-2-
inventories/; 21 October 2017
3. Inventory Management; http://www.apics.org/apics-for-individuals/apics-magazine-
home/compilations/inventory-management; 21 October 2017
4. Inventory Management;
https://msu.edu/course/prr/473/oldstuff/Inventory%20Management.htm; 21
October 2017
Online Instructional Videos
1. What Is Inventory Management?; https://www.youtube.com/watch/sl5zEPRkp0U ; 21
October 2017
2. Inventory Management; http://www.investopedia.com/video/play/inventory-
management/; 21 October 2017

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3. Inventory Accounting For Purchase Commitments (Liabilities Vs Unrealized Losses);
https://www.youtube.com/watch/xgkm7KbEGhg/inventory-accounting-for-purchase-
commitments-liabilities-vs-unrealized-losses.html; 21 October 2017
4. Purchase Commitments; https://www.youtube.com/watch/9mbFt_a_r78/purchase-
commitments.html; 21 October 2017
5. Inventory Errors Accounting (Beginning & Ending Inventory Errors Affect On Net
Income); https://www.youtube.com/watch/w-Dok8h-MkM/inventory-errors-
accounting-beginning-ending-inventory-errors-affect-on-net-income.html ; 21 October
2017