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Inventories

LEARNING OUTCOME
The students should be able to account and prepare entries for inventory
transactions using different inventory systems. Moreover, the students should
be able to properly measure the inventories at LCNRV.
 The students should be able to prepare an inventory cost flow using different
cost formulas such FIFO, LIFO, specific identification, and weighted average
whether under periodic or perpetual method.
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INTRODUCTION AND CORE VALUES INTEGRATION
In any business or organization, all functions are interlinked and connected to
each other and are often overlapping. Some key aspects like supply chain
management, logistics and inventory form the backbone of the business delivery
function. Therefore, these functions are extremely important to marketing managers
as well as finance controllers.
Inventory management is a very important function that determines the health
of the supply chain as well as the impacts the financial health of the balance sheet.
Every organization constantly strives to maintain optimum inventory to be able to
meet its requirements and avoid over or under inventory that can impact the financial
figures. Inventory is always dynamic. Inventory management requires constant and
careful evaluation of external and internal factors and control through planning and
review. Most of the organizations have a separate department or job function called
inventory planners who continuously monitor, control and review inventory and
interface with production, procurement and finance departments.
“Meditating on God’s word makes you wiser than your enemies, gives you more
insight than your teachers and gives you more understanding than your elders.”
INVENTORIES
PAS 2, paragraph 6, defines inventories as assets which are 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.
Classes of Inventories
1. Inventories of a trading entity – one that buys and sells in same form
purchased.
2. Inventories of manufacturing entity – one that buys goods which are altered
or converted into another form before they are made available for sale. The
terms finished goods, goods in process, raw materials and factory or
manufacturing supplies refer to the inventories of a manufacturing entity.
 The general rule is that “all goods to which the entity has title shall be
included in the inventory regardless of location.”
 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.
FOB destination – means that the ownership of the goods purchased is vested in the
buyer upon receipt thereof.
FOB shipping point – means that the ownership of the goods purchased vested in the
buyer upon the shipment thereof.
Freight collect – means that the freight charge on the goods shipped is not yet paid.
Under this, the freight charge is actually paid by the buyer.
Freight prepaid - means that the freight charge on the goods shipped is already paid
by the seller.
Consignment is a method of marketing goods in which the owner known as the
consignor transfers physical possession of certain goods to an agent known as the
consignee who sells the goods on the owner’s behalf. Goods on consignment shall be
included in the consignor’s inventory and excluded from the consignee’s inventory.
Systems of Accounting for Inventories
1. Periodic or Physical System – calls for the physical counting of goods on hand
at the end of the accounting period to determine quantities. It is generally used
when the individual inventory items have small peso investment such as
groceries, hardware and auto parts.
2. Perpetual System – requires the keeping of stock cards that summarize
inventory inflow and outflow. Under this approach, the cost of goods sold is
computed every time of sale. A physical count of the units on hand should at
least be made once a year or at frequent intervals to confirm the balances
appearing on the stock cards.
Methods of recording purchases
1. Gross Method – the purchases are recorded at the gross amount of the invoice.
2. Net Method – the purchases are recorded at net amount, meaning the cost of
purchases is measured net of cash discounts allowable whether taken or not
taken.
The cost of an inventory comprises:
1. Cost of Purchase – comprises the purchase price, import duties and
irrevocable taxes, freight, handling and other cost directly attributable to the
2.
3.
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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 – includes direct labor and systematic allocation of fixed
(normal capacity) and variable production overhead that is incurred in
converting materials into finished goods.
Other cost incurred in bringing the inventory to its present location and
condition.
Abnormal amounts of wasted materials, labor and other production costs,
storage cost, distribution cost, administrative overheads that do not contribute
in bringing inventories to their present location and condition are expensed and
are excluded from the cost of inventory.
However, storage costs related to goods in process or part finished goods are
inventoriable.
INVENTORY VALUATION
PAS 2 provides the following clearcut principles concerning measurement of
inventory:
a. Paragraph 9, LCNRV or Lower of cost and net realizable value
b. Paragraph 25, FIFO (first-in, first-out) method or weighted average method.
LIFO (last-in, last-out) is prohibited in PAS 2.
c. Paragraph 23, Specific Identification Method
FIFO method assumes that goods first purchased are first sold. The inventory is thus
expressed in terms of recent or new prices while the COGS is representative of earlier
or sold prices.
Weighted Average Method
Periodic weighted method
Moving
average
method
(Perpetual
System)
The cost of the beginning inventory plus A new weighted average unit cost must be
the total cost of purchase during the computed after every purchase and
period is divided by the total units purchase return.
purchased plus those in the beginning
inventory to get a weighted average unit
cost.
LIFO method assumes that goods last purchased are first sold. The inventory is thus
expressed in terms of earlier or old prices while the COGS is representative of recent
or new prices.
Specific Identification method – means that specific costs are attributed to
identified items of inventory. It is used when the cost of inventory is not ordinarily
interchangeable and inventories that are segregated for specific projects.
Net Realizable Value or NRV is the estimated selling price in the ordinary course of
business less the estimated cost of completion and estimated cost of disposal.
 Inventories are usually written down to NRV on an item by item or individual
basis.
 If the cost is lower than the NRV, the inventory is stated at cost and the
increase in value is not recognized.
 If NRV is lower than the cost, the inventory is measured at NRV and the
decrease in value is recognized as expense.
Method of accounting for inventory writedown to NRV
1. Direct Method – recorded at the lower of cost or net realizable value. It is
known as the “cost of goods sold method” because any loss in inventory
writedown is not accounted for separately but buried in the COGS.
2. Allowance Method – recorded at cost and any loss on inventory writedown
is accounted for separately. It is also known as “loss method method”
because a loss amount, “loss on inventory writedown” is debited and a
valuation account “allowance for inventory writedown” is credited for the
inventory writedown.
 When agricultural crops have been harvested or mineral ores have been
extracted and a sale is assured under a forward contract or a government
guarantee, PAS 2, paragraph 4, provides that inventories of agricultural forest
and mineral products are measured at NRV.
 PAS 2, paragraph 3, provides that commodities of broker-traders are
measured at fair value less cost of disposal.
 Standard costs are predetermined product cost established on the basis of
normal levels of materials and supplies, labor, efficiency and capacity
utilization.
 Relative sales price method of inventory is based on the philosophy that cost
is proportionate to selling price.
 Purchase Commitments are obligations of an entity to acquire certain goods
sometime in future at a fixed price and fixed quantity.
REFERENCES
Intermediate Accounting Part 1A by Zeus B. Millan, latest edition
Intermediate Accounting Volume 1 First Part by Valix, Peralta, Valix (latest edition)