FINANCIAL ACCOUNTING & REPORTING 1

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Inventories

Module 019 Accounting for Inventories

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

8.6 Inventory estimation methods
✓ Gross profit method
✓ Retail inventory method
8.7 Valuation at lower cost and net realizable value

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

1. Estimate the cost of inventories using estimating procedures and
understand the applicability of each estimating procedure; and
2. Measure inventories based on the lower cost and net realizable value

8.6 Inventory estimation methods

When inventory items cannot be physically counted anymore as the goods may have been
damaged by or lost in catastrophes such as fire or flood, or when the inventory or cost of
goods sold would be presented in the interim financial statements such that a complete
physical count may be too impractical, or to validate inventory figures determined through
physical count.
There are two common methods of estimating the cost of inventory: the Gross Profit
Method and the Retail Inventory Method.
Gross profit method (GPM)
This method of estimating the inventory is based on an assumed relationship:
a) between gross profit and sales; or
b) between gross profit and cost of sales.
GPM depends on the accuracy of the gross profit percentage. That accuracy may
be enhanced by adjustments for known changes in the relationship between gross
profit and sales and varying gross profit rates in different departments or types of
inventory.

For the purposes of computing the cost of goods available for sale, both purchase
returns and purchase discounts are taken into consideration. The reason is that the
net cost of purchases is actually experienced or incurred before setting up the sales
price.
However, for purposes of computing the cost of goods sold using the GPM, net sales
are computed by deducting sales returns only (sales discounts are ignored). Sales
discounts are normally disregarded in net computing sales (only for the purpose of
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computing the cost of goods sold by applying the gross profit rate) because sales
discounts do not involve the physical flow of merchandise back to the company.

The calculation of inventory under this method is as follows:

Beginning inventory xx
Add : Net Purchases xx
Cost of goods available for sale xx
Less: Estimated cost of goods sold (xx)
a. Gross profit rate is based on
sales
Net sales x ( 100%-GP rate)
Or
a. Gross profit based on cost
Net Sales / (100% + GP rate)
Estimated Cost of Inventory xx

When there is undamaged or partially damaged merchandise, computation of

inventory loss is further continued as follows:

Estimated cost of ending inventory xx

Less: Cost of undamaged inventory xx

Realizable value of partially damaged xx xx

(not to exceed cost)

Estimated inventory loss xx
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A summary of steps in the gross profit method is given below:

• Calculate the cost of goods available for sale as the sum of the cost of
beginning inventory and cost of net purchases.
• Determine the gross profit ratio. Gross profit ratio equals gross profit
divided by sales. Use projected gross profit ratio or historical gross profit
ratio, whichever is more accurate and reliable.
• Multiply sales made during the period by gross profit ratio to obtain
the estimated cost of goods sold.
• Calculate the cost of ending inventory as the difference between the
cost of goods available for sale and the estimated cost of goods sold.

To illustrate, assume the following figures for DCB Co. for the six months ended June
30, 2016:
Inventory, January 1 500,000
Purchases 2,000,000
Sales 3,000,000
Purchase Returns 80,000
Purchase Discounts 5,000
Sales Returns 60,000
Sales discount 4,000

Determine the estimated cost of the June 30, 2016 inventory, assuming that the
entity maintains a gross profit rate of:
a. 25% on sales
b. 25 on the cost of sales

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The cost of goods available for sale is determined as follows:

Inventory, January 1 500,000

Add: Net cost of purchases
Purchases 2,000,000
Purchase Returns (80,000)
Purchase Discounts (5,000)
Net purchase 1,915,000
Cost of goods available for sale 2,415,000

To determine the cost of ending inventory in both scenarios, refer below.

The cost of ending inventory as of June 30, 2016, is determined as follows:

GP rate is 25% GP rate is 25% based
based on sales on the cost of sales
Cost of goods available for sale 2,415,000 2,415,000

Estimated cost of sales

2,940,000 * 75% 2,205,000

2,940,000 / 125% 2,342,000

Estimated ending inventory 210,000 73,000

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Retail inventory method

For retailers, where the count is an enormous task where there are large numbers
of rapidly changing items with similar margins, estimates are used for interim
reporting. The cost of the inventory is determined by reducing the sales value
of the inventory 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. (PAS 2, par.22)
The retail inventory method requires the maintenance of records of purchases at
both costs and selling prices. A ratio of cost to retail is calculated and applied to the
ending inventory at retail to compute the approximate cost.

When using this method, the appropriate treatments for some costs are as follows:
• Freight-in is an addition to purchases at cost.
• Purchase discounts and purchase allowances are deductions from
purchases at cost only
• Purchase returns are deducted from the cost and retail amounts of
purchases
• Sales returns are deducted from retail sales
• Sales discounts and allowances are not deducted from retail sales
• Departmental transfer-in (debit) is an addition to both cost and the retail
amount of purchases
• Departmental transfer-out (credit) is a deduction from both cost and retail
amounts of purchases
• Normal losses, shortage, and shrinkage are deducted from the goods
available for sale at retail after computing the cost ratio
• Abnormal losses are deducted from both cost and retail amounts of
purchases before computing the cost ratio
• Discounts to employees and favored customers are deducted from the
goods available for sale at retail after computing the cost ratio (in addition to
sales).

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The original selling price of the goods may be modified as a result of some market
and economic forces, thus the following terms:
Original Retail - the first selling price at which goods are offered for sale
Markup or additional markup – an increase in the selling price over the
original retail price
Markdown - decrease in the selling price below the original retail price
Markup cancellation - a decrease in the selling price which does not bring the
new selling price below the original retail
Markdown cancellation – an increase in the selling price which does not
bring the new selling price above the original retail price
New markup - markup less markup cancellation
Net markdown – markdown less markdown cancellation

Follow the steps below in the computation of the estimated ending inventory:
1. Calculate goods available for sale at both cost and retail
Beginning inventory plus purchases
2. Calculate the cost-to-retail ratio
Goods available for sale at cost divided by the goods available for sale at retail
3. Calculate the ending inventory at retail
Goods available for sale at retail fewer sales
4. Calculate the ending inventory at an estimated cost
Ending inventory at retail multiplied by the appropriate cost-to-retail ratio
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Illustration 1
• An item costing 100 is initially marked to sell at 150. The original
retail is, therefore, 150.

• If the selling price of this merchandise is subsequently increased to

170, the additional markup is 20.

• If the selling price is then decreased from 170 to 155, the markup
cancellation is 15.

• The difference between additional markup of 20 and the markup

cancellation of 15, which is 5, is called net markup.
Illustration 2
• An item costing 100 is initially marked to sell at 150. The original
retail is, therefore, 150.

• If the selling price of this merchandise is subsequently increased to

135, the markdown is 15.

• If the selling price is then increased from 135 to 145, the markdown
cancellation is 10.

• The difference between an additional markdown of 15 and the

markdown cancellation of 05, which is 5, is called net markdown.

The net markups and markdowns, as well as the beginning inventory, are included
in the computation of the cost percentage to be applied to the retail ending
inventory. The approximate average of the inventory is then compared with the net
realizable value. The lower between the cost and the net realizable value is the
inventory amount that will be presented in the statement of financial position.

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The following computations illustrate the use of the FIFO retail inventory method:

Cost Retail

Beginning inventory 70,000 126,000

Purchases 340,000 438,000

Purchase Returns (20,000)

Purchase Allowances (2,000)

Purchase Discounts (1,200)

Freight-in 4,000

Additional markups (net) 24,000

Markdowns (net) (10,000)

Abnormal losses (18,000) (22,000)

Departmental Transfer out (8,800) (12,000)

294,000 394,000

Goods available for sale 364,000 520,000

Cost-to-retail ratio = 294,000/ 394,000 = 74.62%

Deduct:

Sales 380,000

Sales returns (15,000)

Employee discounts 1,500

Normal Losses 2,500

Total 369,000

Ending inventory, retail 151,000

Ending inventory at an estimated

cost
Ending inventory, retail * cost %

151,000 * 74.62% 112,676

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The following computations illustrate the use of Average Approximate Cost:

Cost Retail

Beginning inventory 70,000 126,000

Purchases 340,000 438,000

Purchase Returns and allowances (22,000)

Purchase Discounts (1,200)

Freight-in 4,000

Additional markups (net) 24,000

Markdowns (net) (10,000)

Abnormal losses (18,000) (22,000)

Departmental Transfer out (8,800) (12,000)

294,000 394,000

Goods available for sale 364,000 520,000

Cost-to-retail ratio = 364,000/520,000= 70%

Deduct:

Sales 380,000

Sales returns (15,000)

Employee discounts 1,500

Normal Losses 2,500

Total 369,000

Ending inventory, retail 151,000

Ending inventory at an estimated

cost
Ending inventory, retail * cost %

151,000 * 70% 105,700

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 When the retail method assumes a FIFO cost outflow, the cost and the retail value of
beginning inventory are excluded from the cost ratio computation. The cost
percentage that will be developed is the ratio of the current cost of purchases to the
current retail prices of these purchases (adjusted for net markups and net
markdowns). The approximate cost of the ending inventory is, therefore, based on
the ratio of cost to retail on the current period purchase only.
When the net markdowns are excluded from the cost ratio computation, the cost to
retail will be slightly decreased, giving an ending inventory that directly
approximates the lower cost and net realizable value.
The amount of ending inventory at retail would be the same in the above
computations; however, the estimated cost of the ending inventory would vary
depending on the cost ratio applied. The method prescribed by PAS 2 is the method
that considers the net markdowns in the computation of the cost ratio, eliminating,
in effect, the use of the conventional retail method.

8.7 Valuation at lower cost and net realizable value

A primary issue in accounting for inventories is the amount of cost to be recognized as an
asset and carried forward until the related revenues are recognized. The focus on
accounting from an inventories' standpoint should be on the balance sheet.
PAS 2 provides practical guidance on the determination of cost and its subsequent
recognition as an expense, including any write-down to net realizable value (NRV). It also
provides guidance on the cost formula that is used to assign costs to inventories.
When measuring the client’s inventories, there are other considerations related to net
realizable value.
To explore net realizable value issues to consider, we should know:

Is it possible to Is it possible to
Are the inventory measure on an measure on an
costs recoverable? item-by-item basis? item-by-item basis?

In what form will Should we consider What if the cost of

the inventories be the value of work the finished
sold? in progress? product exceeds
NRV?
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To explore net realizable value issues to consider, we should know:

There are a number of possible causes of the inventory cost
Are the inventory becoming not recoverable:
costs recoverable? • Physical damage
• Obsolescence (partially or wholly obsolete)
• Fall in selling price
• Rise in completion costs
(PAS 2, Inventories, par. 28)

In principle, the lower cost and net realizable value test should
Is it possible to generally be applied on an item-by-item basis unless items are
measure on an sold only in combination with other items, in which case they
item-by-item basis? should be considered together.
Service providers generally accumulate costs in respect of each
service for which a separate selling price is charged. Therefore,
each such service is treated as a separate item.

In some circumstances, however, it may be appropriate to group

Should we similar or related items. This may be the case with items of
aggregate the inventory relating to the same product line that have similar
items? purposes or end uses, are produced and marketed in the same
geographical area, and cannot be practicably evaluated separately
from other items in that product line. A broad-brush approach that
looks at inventories in large categories would not meet the
requirements of PAS 2 because losses in the value of individual
items of inventory would be masked by unrealized gains on
others.
It is not appropriate to write down inventories on the basis of a
classification of inventory, for example, finished goods or all the
inventories in a particular industry or geographical segment.
(PAS 2, Inventories, par. 29)

In applying the cost vs. net realizable value test, it is relevant to

In what form will consider the form in which the inventories will be sold. This
the inventories be means that materials and other supplies held for use in the
sold? production of inventories 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.
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 Should we As with raw materials, it is not necessary to consider the net
consider the value realizable value of work in progress in its existing state but rather
of work in to look at the eventual selling price of the completed product, less
progress? the conversion cost to complete it and the estimated costs to sell it.

A new assessment is made of the net realizable value in each

What if the cost of subsequent period. When the circumstances that previously
the finished caused inventories to be written down below cost no longer exist
product exceeds or when there is clear evidence of an increase in net realizable
NRV? value because of changed economic circumstances, the amount of
the write-down is reversed (i.e., the reversal is limited to the
amount of the original write-down) so that the new carrying
amount is the lower of the cost and the revised net realizable
value. Any write-down to net realizable value is reversible; the
lower cost and net realizable value test should be recalculated at
each balance sheet date.
When there is a direct correlation in the market between the price
of raw materials and the price of finished goods (for example, the
price of rubber to the manufacturer and the price of tires), should
there be a significant decline in the price of the raw materials after
the goods have been manufactured, this may indicate that the cost
of the finished products exceeds the net realizable value.
If the cost is lower than the net realizable value, there is no accounting problem because
the inventory is stated at cost, and the increase in value is not recognized.
If the net realizable value is lower than the cost, the inventory is measured at the net
realizable value. In this case, the problem is the proper treatment of the write-down of the
inventory to net realizable value.
There are two methods of accounting for the inventory write-down, namely:

1. Direct method

The inventory is recorded at a lower cost or net realizable value. Any loss on
inventory write-down is not accounted for separately but "buried" in the cost of
goods sold.

2. Allowance method

The inventory is recorded at cost, and any loss on inventory write-down is

accounted for separately. In other words, under this method, a loss account "loss on
inventory write-down" is debited, and a valuation account "allowance for inventory
write-down" is credited.
In subsequent years, this allowance account is adjusted upward or downward
depending on the difference between the cost and realizable value of the inventory
at year-end.
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If the required allowance increases, an additional loss is recognized. If the required

allowance decreases, a gain on reversal of inventory write-down 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 effects of write-down and
reversal of write-down can be clearly identified.
As a matter of fact, PAS 2 requires disclosure of the amount of any inventory write-
down and the amount of any reversal of inventory write-down.

Illustration
The inventory records showed the following data on December 31, 2016.

Units (b) Unit (c)

Cost NRV
Materials
No. 1 1,000 11 10
No. 2 3,000 23 25
No. 3 2,000 30 32
Goods in the
process:
X 5,000 40 38
Y 3,000 50 52
Finished goods:
A 2,000 75 73
B 2,000 80 83

Observe the measurement of the inventory at the lower cost, or NRV is applied on
the item by item or individual basis.

Total Cost NRV Lower

Materials
No. 1 11,000 10,000 10,000
No. 2 69,000 75,000 69,000
No. 3 60,000 64,000 60,000
Goods in the process:
X 200,000 190,000 190,000
Y 150,000 156,000 150,000
Finished goods:
A 150,000 146,000 146,000
B 160,000 166,000 160,000
800,000 785,000

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Direct method

The inventory is recorded at a lower cost or net realizable value. Thus, the entry to
record the inventory on December 31, 2016, is:
Inventory- December 31, 2016 785,000
Income Summary 785,000

The loss on inventory write-down of P15, 000 is not accounted for separately. The
entry will have the effect of increasing the cost of goods sold because the net
realizable is lower than the cost.

Continuing the illustration, assume on December 31, 2017, the total cost of the
inventory is P1, 000, 000 and the net realizable value is P990, 000

Again, under this method, the inventory is simply recorded at a lower amount. Thus,
the entry to record the inventory on December 31, 2017, is:
Inventory- December 31, 2016 990,000
Income Summary 990,000

Allowance method
The inventory on December 31, 2016, is recorded at cost as follows:
Inventory - December 31, 2016 800,000
Income Summary 800,000
The loss on inventory write-down is accounted for separately as follows:
Loss on inventory writedown 15,000
Allowance for inventory write-down 15,000
The loss on inventory write-down is included in the computation of the cost of
goods sold. The allowance for inventory write-down is presented as a deduction
from the inventory.
Inventory- December 31, 2016, at cost 800,000
Allowance for inventory write-down (15,000)
Net Realizable value 785,000

Continuing the illustration, assume on December 31, 2017, the total cost of the
inventory is P1, 000, 000 and the net realizable value is P990, 000
Cost 1,000,000
Net realizable value 990,000
Required allowance- December 31, 2017 10,000
Less: Allowance balance- December 31, 2016 15,000
Decrease in allowance (5,000)
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The decrease in allowance is a reversal of the previous inventory write-down and is

recorded as follows:
Allowance for inventory write-down 5,000
Gain on reversal of inventory write-down 5,000

The gain on reversal of inventory is presented as a deduction from the cost of goods
sold. This is in accordance with PAS 2, paragraph 34, which provides that "the
amount of any reversal of any write-down 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.

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Glossary
Abnormal inventory loss: loss in inventory units and/or amount due to unforeseen
circumstances
Fair value: is the amount for which an asset could be exchanged or a liability could be
settled between knowledgeable, willing parties in an arm's length transaction.
Firs-in, First out: method of allocating cost to inventory items that assume that the items
purchased first will be the items first sold
Gross method: a method of inventory accounting that records inventory cost before
considering cash discounts
Gross profit method: an inventory estimation technique based on the relationship
between gross profit and sales
Markup: an increase in the selling price over the original retail price
Markdown: a decrease in the selling price below the original retail price
Net method: a method of recording purchases at the invoices price less any cash discount
offered by the seller
Net realizable value: the estimated selling price in an ordinary course of business less the
estimated cost of completion and the estimated costs necessary to make the sale.
Normal inventory loss: loss in inventory units and/ or amount due to foreseen events and
loss considered within tolerable limit.
Retail inventory method: a method used by companies in the retail industry where the
estimated cost of inventory is based on the assumed relationship between cost and retail
prices after considering the changes in the original retail price.
Weighted average; is a method of allocating cost to inventory items based on the weighted
average of the cost of similar items at the beginning of a period and the cost of similar items
purchased or produced during the period.
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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. 8.4 Reporting Inventory at the Lower-of-Cost-or-Market;
http://open.lib.umn.edu/financialaccounting/chapter/8-4-reporting-inventory-at-
the-lower-of-cost-or-market/; 21 October 2017
2. 8.5 Determining Inventory on Hand;
http://open.lib.umn.edu/financialaccounting/chapter/8-5-determining-inventory-
on-hand/; 21 October 2017
3. IAS 2 Inventories; http://www.ifrs.org/issued-standards/list-of-standards/ias-2-
inventories/; 21 October 2017

Online Instructional Videos

1. Financial Accounting - Chapter 6: Inventories;
https://www.youtube.com/watch?v=9bo12RbWhm8; 21 October 2017
2. Gross Profit Margin | Inventory Accounting | CA CPT | CS & CMA Foundation |
Class11 | Class12; https://www.youtube.com/watch/43wjro7Bq_U/gross-profit-
margin-inventory-accounting-ca-cpt-cs-cma-foundation-class11-class12.html; 21
October 2017;
3. Estimating inventory gross profit method intermediate accounting cpa exam ch 9 p
4; https://www.youtube.com/watch/69PYPyYJbSA/estimating-inventory-gross-
profit-method-intermediate-accounting-cpa-exam-ch-9-p-4.html; 21 October 2017;
4. Retail inventory method- Intermediate Accounting CPA exam chapter 9 example;
https://www.youtube.com/watch/rqk0iRgDkbE/retail-inventory-method-
intermediate-accounting-cpa-exam-chapter-9-example.html; 21 October 2017
5. Retail Inventory Method (Markups, Markdowns With Cancellations, Basic
Calculations); https://www.youtube.com/watch/0C-D3as5gPg/retail-inventory-
method-markups-markdowns-with-cancellations-basic-calculations.html; 21
October 2017

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