Module 12: Inventories, Government Grant and Agriculture Part 1

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 rendering of services.
Inventories encompass goods purchased and held for resale, for example:
1. Merchandise purchased by a retailer and held for resale
2. Land and other property held for resale by 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
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
COST OF PURCHASE
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.
COST OF CONVERSION
The costs of conversion of inventories include costs directly related to the units of
production, such as direct labour. They also include a systematic allocation of fixed and
variable production overheads that are incurred in converting materials into finished
goods.
Fixed production overheads are those indirect costs of production that remain relatively
constant regardless of the volume of production, such as depreciation and maintenance of
factory buildings and equipment, and the cost of factory management and administration.
Variable production overheads are those indirect costs of production that vary directly,
or nearly directly, with the volume of production, such as indirect materials and indirect
labour.
OTHER COST
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.
Examples of costs excluded from the cost of inventories and recognized as expenses in the
period in which they are incurred are:
 Abnormal amounts of wasted materials, labour or other production costs;
 Storage costs, unless those costs are necessary in the production process before a
further production stage
 Administrative overheads that do not contribute to bringing inventories to their
present location and condition
 Distribution or selling costs
COST OF INVENTORIES FOR SERVICE PROVIDER
To the extent that service providers have inventories, they measure them at the costs of
their production. These costs consist primarily of the labour and other costs of personnel
directly engaged in providing the service, including supervisory personnel, and attributable
overheads.
Labour and other costs relating to sales and general administrative personnel are not
included but are recognized as expenses in the period in which they are incurred. The cost
of inventories of a service provider does not include profit margins or non-attributable
overheads that are often factored into prices charged by service providers
COST OF FORMULAS
PAS 2, paragraph 25, expressly provides that the cost of inventories shall be determined
by using either:
1. FIRST IN, FIRST OUT
2. WEIGHTED AVERAGE
FIRST IN, FIRST OUT (FIFO)
The FIFO method assume that “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 good 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 good sold are stated at earlier or older prices resulting understatement of cost
of good sold. Accordingly, in a period of inflation or rising price, 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.
 Illustration - FIFO
The following data pertain to an inventory item:
Units Unit cost Total cost Sales(in units)
Jan. 1 Beginning balance 800 200 160,000

8 Sale 500

18 Purchase 700 210 147,000

22 Sale 800
31 Purchase 500 220 110,000
The ending inventory is 700 units.

Units Unit cost Total Cost

From Jan. 18 Purchase 200 210 42,000
From Jan. 31 Purchase 500 220 110,000
700 Cost 152,000
ofGoodSold

Inventory - January 1 160,000

Purchases 257,000
Goods available for sale 417,000
Inventory - January 31 (152,000)
Cost of Good Sold
Jan. 18 Purchases
Jan. 31 Purchases 110,000
Total Purchases 257,000
WEIGHTED AVERAGE
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 bu dividing the total
cost of goods available for sale by the total number of units available for sale.
The preceding illustrative data are used:
Units Unit Cost Total
Cost
Jan. 1 Beginning balance 800 200 160,000
19 Purchase 700 210 147,000
 31 Purchase 500 220 110,000
Total goods available for sale 2,000
Weighted average unit cost (417,000/2,000)
Inventory cost (700 x 208.50) 145,950 The
Cost ofgoodsold

Inventory - January 1 160,000

Purchases 257,000
Goods available for sale 417,000
Inventory - January 31 (145,950)
Cost of goods sold 271,050
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 in thus expresses 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 a matching of current against current revenue, the cost of goods sold being
expressed in terms of current r 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.Actually, in a period of rising prices, the LIFO method would result to the
Units Unit Cost Total
Cost
From January 1 balance 700 200 140,000

Inventory - January 1 257,000

160,000
lowest net income. In a period of declining prices, the LIFO method would 417,000
result to the highest net income. (140,000)
277,000
Illustration - LIFO
In the preceding illustration, the cost of 700 units under the LIFO is computed as follows:
Purchases
Goods available for sale
Inventory - January 31 Cost of Good Sold
SPECIFIC IDENTIFICATION
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
and the actual unit cost. 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.
MEASUREMENT OF INVENTORY
PAS 2, paragraph 9, provides that inventories shall be measured at the lower of cost and
net realized value. The cost inventory id determined using ether FIFO cost or average cost.
The measurement of inventory at the lower cost and net realized value is known as LCNRV.
NET REALIZABLE VALUE
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.
Inventories are usually written down to net realizable value on an item by item or
individual basis.
The cost of inventories may not be recoverable under the following circumstances.
 The inventories are damaged.
 The inventories have become wholly or partially obsolete. The selling prices
have declined.
 The estimated cost for completion or the estimated cost of disposal has increased.
ACCOUNTING FOR INVENTORY WRITTEN DOWN
If the cost is lower than 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 cost, the inventory is measured at net realizable value.
In this case, the problem treatment of the write down of the inventory to net realizable
value is accounted for using the allowance method.
ALLOWANCE METHOD
The inventory is recorded at cost and any loss on inventory 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 require allowance increases, an additional loss is recognized. If the required allowance
decreases, a gain on reversal inventory writedown is recorded.
However, the gain is limited only to the extent of the allowance balance. The allowance
method is used in order to effects of writedown and reversal of writedown can be clearly
identified. As a matter of fact, PAS 2, paragraph 26, requires disclosure of the amount of
inventory writedown and the amount of any reversal of inventory writedown.

Illustration - Inventory data on December 31,2020

Inventory item Total Cost NRV LCNRV
A 2,000,000 1,900,000 1,900,000
B 1,500,000 1,550,000 1,500,000
C 2,500,000 2,100,000 2,100,000
D 3,000,000 3,200,000 3,000,000
Total 9,000,000 8,750,000 8,500,000
The measurement of the inventory at LCNRV is applied on an item by item or individual
basis or Php 8,500,000
Total cost 9,000,000
LCNRV 8,500,000
Inventory writedown 500,000
JOURNAL ENTRIES
The inventory on December 31, 2020 is recorded at cost.
Inventory - December 31, 2020 9,000,000
Income Summary 9,000,000
The loss on inventory writedown is accounted for separately/
Loss on inventory writedown 500,000 Allowance for inventory
writedown 500,000
The loss on inventory writedown is included in the computation of cost of good sold. The
allowance for inventory writedown is presented as a deduction from the inventory.
Inventory - December 31, 2020, at cost 9,000,000
Allowance for inventory writedown (500,00)
Net realized value 8,500,000