Inventory The primary basis of accounting for inventories is cost.

In general cost, is the price paid or consideration given to acquire an asset. As applied to inventories, it represents the direct and indirect expenditures for items purchased, produced or in the process of production including the cost of production overhead. It constitutes the sum of applicable expenditures and charges directly or indirectly incurred in bringing the inventory items to their existing condition and location. Inventories are normally valued at historical cost. However, whenever the utility of the goods becomes lower than cost, due to damage, physical deterioration, obsolescence, changes in price levels or other causes, the goods should be stated at the lower level or conservative value commonly designated as market. Inventories are generally classified as current assets. The nature of a business determines the designation of an item as inventory. In a merchandising concern, inventories generally consist of merchandise on hand, in transit, in storage or on consignment. In a manufacturing business, inventories generally consist of finished goods (completed products held for sale), work in process (goods being produced), and raw materials and supplies (goods entering directly or indirectly into the production of finished goods) on hand and in transit. In a service company, inventories may include operating supplies. Items Included in Inventory Correct inventory valuation requires an accurate count of the inventory items. This starts with the counting of all the items in the warehouse. However, there may be items in the warehouse that are not owned by the entity; these items must be excluded from the count. There may also be items that are not in the warehouse that should be included in the inventory. The following items should be noted: Goods in transit purchased FOB shipping point are included in the count. Goods in transit purchased FOB destination are excluded from the count. Goods in transit sold FOB destination are included in the count. Goods in transit sold FOB shipping point are excluded from the count. Goods out on consignment are included in the count. Goods accepted on consignment are excluded from the count.

Consignment is a way of selling certain types of goods. The consignor delivers the goods to the consignee who endeavors to sell the goods to consumers for a commission or fee. The consignor still owns the consigned goods and as such should include them in the inventory. Inventory Systems Inventory records maybe maintained using the periodic or perpetual method. Periodic inventorysystem, purchases of goods are debited to the Purchases account and not to inventory. Perpetual inventory system, the Inventory account is debited when goods are purchased and credited when goods are sold. Inventory Costing Methods Cost flow is the real or assumed association of unit costs with good either sold or on hand. The assumed cost flow does not always reflect the actual goods flow. The generally accepted methods of inventory costing under the periodic inventory system are as follows: 1. 2. 3. 4. Specific Identification First-In, First-Out Last-In, First-Out Weighted-Average Cost

Illustration. Robin Padilla Sales in Cagayan de Oro City sells novelty items including specially designed pins. At the beginning of the year, Robin Padilla has 1,000 pins. During 2009, a total of 8,000 pins were purchased. At the end of 2009, there are 3,500 pins left in the stockroom. A summary of the inventory activities follows: Units Beginning Inventory Purchase #1 Purchase #2 Purchase #3 Cost of Goods Available for Sale Ending Inventory Units Sold P 1,000 3,000 2,000 3,000 9,000 3,500 5,500 Cost P10 14 16 18 P Total 10,000 42,000 32,000 54,000___ P 138,000

First-In, First-Out Method This cost flow assumption presumes that the first items into the stockroom are the first out. Goods sold are assigned the cost of the oldest inventory available. Ending inventory is to be valued at the most recent costs. The value of the ending inventory and cost of goods sold of Robin Padilla would be computed as follows: The ending inventory is P62,000 which consists of the newest 3,500 units 3000 @ P18 500 @ P16 P 54,000 8,000 P 62,000 Cost of goods sold equals the cost of goods available for sale of P138,000 minus the ending inventory of P62,000 or P76,000. The oldest 5,500 units were sold so the cost of goods sold may alternatively be computed as: 1,000 @ P10 3,000 @ P14 1,500 @ P16 P10,000 42,000 24,000 P 76,000

Last-In, First-Out Method This cost flow assumption suggests that the newest items are the first sold. This means that the most recent costs are used to value the cost of goods sold. This method is the opposite of firs-in, first-out.

The value of the ending inventory and cost of goods sold of Robin Padilla would be computed as follows: The ending inventory is P45,000 which consists of the oldest 3,500 units 1,000 @ P10 2,500 @ P14 P 10,000 35,000 P 45,000 The cost of goods sold equals the cost of goods available for sale of P138,000 minus the ending inventory of P45,000 or P93,000. The newest 5,500 units were sold so the cost of goods sold may alternatively be computed as: 3,000 @ P18 2,000 @ P16 500 @ P14 P54,000 32,000 7,000_ P 93,000_ Weighted-Average Cost The weighted-average cost flow assumption implies that the items in an inventory are sold at random. This means that the items in the ending inventory could include some of the original items from the beginning balance and some from each purchase made during the period. The items are assigned a weighted-average cost. The formula used to compute the weighted-average unit cost for Robin Padilla follows: Cost of Goods Available for Sale Weighted-Average Unit Cost = ______________________________ Units Available for Sale P 138,000 Weighted-Average Unit Cost = _______________________ 9,000 = P15.3333

The ending inventory is then computed by multiplying the weighted-average cost times the number of units in the ending inventory, P15.3333 times 3,500 or P53,667.The cost of goods sold is computed by subtracting the value of the ending inventory from the cost of goods available for sale, P138,000 minus P53,667 or P84,333. Comparison of the Inventory Costing Methods When inventory unit costs are increasing. FIFO ending inventory is highest because it is priced at the most recent costs. LIFO ending inventory is lowest because it is priced at the oldest costs, which are the lowest. When inventory unit costs are decreasing, ending inventory using FIFO is the lowest and highest in LIFO. A tabular comparison of the inventory costing methods follows:

Ending Inventory FIFO LIFO Weighted- Average P 62,000 45,000 53,667

Cost of Goods Sold P76,000 93,000 84,333

LIFO gave the highest cost of goods sold because the newest and most expensive units are assumed to be sold. Thus, LIFO will provide the lowest net income.

Estimating Inventory Gross Profit Method Business must often estimate the value of its inventory in order to prepare interim financial statements. Frequent physical counts to establish inventory amounts are not made for costs considerations. There are times though that physical count is not a possible alternative such as after a calamity. In both cases, the business uses the gross profit method in estimating the cost of ending inventory and the cost of goods sold. Gross profit method relies on the relationship between sales and cost of goods sold. For most entities, the cost of goods sold represents a reasonably stable percentage of sales; in effect, gross profit can also be a predictable percentage of sales. Illustration. On Mar. 21, 2009, the entire inventory of Fernandez Clothes Shop was destroyed by fire. The accounting records kept at the home office indicated that the inventory on Jan. 1, 2009 totaled P125,000. Merchandise worth P280,000 was purchased during the year. Net sales amounted to P425,000 through Mar. 20, 2009. A gross profit rate of 20% of sales has been reasonably maintained. The value of the inventory destroyed by fire can be estimated as follows: Inventory, Jan. 1 Add: Purchases (net) Cost of Goods Available for Sale Less: Cost of Goods Sold Net Sales Percentage of Cost to Sales (100% - 20%) Estimated Ending Inventory P 125,000 280,000 P 405,000 P 425,000 80%

340,000 P 65,000

Internal Control over Inventory Physical count of inventory at least once a year. Maintenance of an efficient purchasing, receiving and shipping procedures. Physical control over inventory to prevent damage, decay and theft. Segregation of custody of inventory and maintenance of accounting records. Use of perpetual inventory system for merchandise with high unit cost. Purchase of inventory in economical quantities to avoid lost sales due to inventory shortage or financial losses due to too much inventory position. PROPERTY AND EQUIPMENT Nature Property and equipment includes all tangible assets with an estimated useful life beyond one year, are used in the conduct of the business, and are not intended for sale in the ordinary course of business. Assets of this nature include the following:

 Property ordinarily not subject to depreciation such as land used as plant site; Property subject to depreciation such as buildings, machinery, equipment, furniture and improvements to leased facilities. Valuation and Classification Property and equipment are generally carried at cost less allowance for depreciation. When classified balance sheet is presented, property and equipment should be reflected as non-current assets.

Classes of Property and Equipment Land The account would include all costs directly attributable to its acquisition and to its conditioning for use. Capitalizable costs may include the following: Purchase price; Attorneys fees and any other expenditure for establishing clean title; Agents commission; Cost of demolition of old structures (salvage from disposal of the old building is considered as a deduction to the land account), clearing and grading; Payments to tenants to induce them to vacate the premises; Cost of relocation or reconstruction of property belonging to others in order to acquire possession; and All expenses that should have been paid by the seller but assumed by the buyer. Buildings Cost of the building itself; Expenditures for service equipment and fixtures made a permanent part of the structure; Permits, architects fees and legal fees; Excavation costs; Costs of temporary structures used as construction offices and stockrooms; Any renovation or remodeling costs incurred to put a building purchased in a condition suitable for its intended use. Machinery and Equipment Costs of the purchase; Transportation costs borne by the buyer of the asset; Insurance while in transit; Labor charges, materials and other expenditures incurred in placing the equipment ready for operation. Land Improvements Driveways, sidewalks, parking lots, fencing and landscaping; Sprinkler, water and drainage systems.

Acquisition Cost
Cash or Short-term Credit The cost of properties acquired by direct cash purchase includes, in addition to the invoice cost, all other expenditures necessary to put the asset in condition and location for use. When property and equipment are acquired on short-term credit, cash discounts are generally considered as reductions of cost even when the discount is not taken. The entry is simply a debit to the specific class of property and equipment, and a credit to cash. Lump Sum Purchase When a group of assets is acquired for a lump-sum price, the total cost should be allocated to the individual assets based on their relative fair values. Fair values should be determined by referring to quoted market

prices, independent appraisals, estimated fair values of assets or services received in exchange and other available evidence. Illustration. Cita Rodriguez organized a lahar-dredging contracting business in San Fernando, Pampanga. The entity registered as Rodriguez Prime Movers acquired the office building, equipment and service vehicle of Cayanan Company for P1, 000,000. The market values are P90, 000 for the office building, P450, 000 for the equipment and P210, 000 for the service vehicle. Rodriguez can allocate the P1,000,000 lump sum purchase price as follows: Market Percent Allocated Value of Total Purchase Price Office Building P 90,000 90/750 P 120,000 Equipment 450,000 450/750 600,000 Service Vehicle 210,000 210/750 280,000 P750,000 P 1,000,000 The allocated purchase price of the office building is derived by multiplying P1, 000,000 by the fraction 90/750 or p120, 000. The acquisition entry would be: Office Building Equipment Service Vehicle Cash 120,000 600,000 280,000 1,000,000

Others Property and equipment can be acquired on installments basis, by issuance of bonds, by exchange, by tradein, or by donation. Each mode of acquisition requires additional considerations and is beyond the scope of basic accounting. Depreciation Nature The process of systematically allocating the cost of property and equipment to expense over the period the asset is used is called depreciation. This process is designed to match the assets expense against the revenue generated over the assets life in accordance with the matching principle. It is a process of cost allocation and not valuation. Depreciation can either by physical or technical. Physical depreciation is due to wear and tear, passage of time, action of the elements, accidents or diseases. Technical depreciation arises from obsolescence or inadequacy. Factors Three factors are considered in determining the amount of depreciation expense to be recognized each period. These include the following: Asset Cost. Estimated Useful Life. It is the estimated length of service expected from an asset. Useful life maybe expressed in years, units of output or other measure. Estimated Salvage Value. It is expected cash value of the asset or the amount that the asset can probably be sold for at the end of its estimated useful life. This is also known as residual value, scrap value or trade-in value. Depreciation Methods The following are the four more common depreciation methods used in business: Straight-Line Method The straight-line method of determining depreciation provides for equal amounts of periodic expense over the estimated useful life of the asset. This method relates depreciation directly to the passage of time.

Depreciable cost of the asset is determined by subtracting the estimated salvage value from the original cost of the asset. The estimated useful life is then divided into the depreciable cost. The resulting amount is an annual depreciation expense that is constant over the life of the asset. Illustration. Barero Enterprises purchased a computer equipment for P90, 000. Shipping charges were P1, 250; installation and programming amounted to P3, 750. The equipment is expected to last four years and has a salvage value of P15, 000. Barero elected to use the straight-line method of depreciation for the computer. The following steps will illustrate the procedures: 1. Purchase price P90,000 Shipping charges 1,250 Installation and programming 3,750 Original cost P95,000 2. Depreciable Cost = Original Cost Salvage Value Depreciable Cost = P95, 000 P15, 000 = P80, 000 3. Annual Depreciation = P80,000 = P20,000 4

End of Year 1 2 3 4

Computer Equipment Straight-Line Depreciation Schedule Annual Accumulated Depreciation Depreciation P20,000 20,000 20,000 20,000 P20,000 40,000 60,000 80,000

Book Value P95,000 (original cost) 75,000 55,000 35,000 15,000 (salvage value)

Note that the initial book value of P95,000 is the original cost of the asset and the final book value of P15,000 is equal to the salvage value of the asset. Book value is original cost less accumulated depreciation. As the computer equipment is used, accumulated depreciation increases and the book value decreases. At the end of its useful life of 4 years, the computer is said to be fully depreciated. The entry to recognize depreciation expense at the end of the first year follows: Depreciation Expense Computer Equipment 20,000 Accumulated Depreciation Computer Equipment

20,000

Units-of-Production Method This method is based on the assumption that the decrease in useful life of the asset is directly related to the amount of time the asset is in use. To apply this method, the life of the asset is expressed in productive capacity such as, units produced, hours used or kilometers driven. Depreciable cost is computed in the same manner as straight-line method. The estimated useful life of the asset, expressed in terms of productive capacity, is then divided into the depreciable cost to arrive at the depreciation per unit, hour or kilometer. This per-unit depreciation is multiplied by the number of units produced each period to determine the depreciation expense. Illustration. Marie Faustine Printing purchased a printing press for P85,000 with a salvage value of P5,000.The press is expected to have a useful life of 5,000 hours. Year 1 2 3 4 Hours Used 1,500 1,200 2,000 500

The following steps will illustrate the procedures: 1. Depreciation per Hour = Cost Salvage Value Hours of Useful Life Depreciation per Hour = P85,000 P5,000 = P80,000 = P16 per hour 5,000 5,000 2. Annual Depreciation = Depreciation per Hour x Hours Used Annual Depreciation (year 1) = P16 x 1,500 = P24,000 Annual Depreciation (year 2) = P16 x 1,200 = P19,200 3. Printing Press Units-of-Production Depreciation Schedule End of Depreciation Hours Annual Accumulated Book Year per Hour Used Depreciation Depreciation Value (new) P85,000 1 P16 1,500 P24,000 P24,000 61,000 2 16 1,200 19,200 43,200 41,800 3 16 2,000 32,000 75,200 9,800 4 16 500 4,800* 80,000 5,000
*Maximum allowable to reach salvage value.

Sum-of-the Years Digits Method The sum-of-the-years digits and the declining-balance methods of calculating depreciation are accelerated depreciation methods. These methods assume that an asset depreciates more in the early years of its useful life than in the later years. Under the sum-of-the years digits method, the yearly charge for depreciation declines steadily over the estimated useful life of the asset because a successively smaller fraction is applied each year to the depreciable cost. This fraction is known as the sum-of-the-years digits fraction. The denominator of the fraction is the sum of the digits of the estimated life of the asset. This number does not change. The numerator of the fraction is the number of years of useful life remaining. This number changes every year. This sum-of-the years digits depreciation rate fraction can be expressed as SYD Depreciation Rate Fraction = Years of Useful Life Remaining Sum-of-the-Digits of the Useful Life

The denominator, the sum of the years-digits, can be calculated by adding all the digits of the years, or by following a formula where n = the number of years of useful life of the asset: SYD ` = n (n + 1) 2

For example, compute the depreciation rate fractions for an asset that has a useful life of 4 years. The denominator, the sum of the digits of 4, is 10. This is calculated by 4 + 3 + 2 + 1 = 10 or by the SYD formula, 4 (4 + 1) - 2 = 10. Remember that the denominator does not change. The numerator of the fractions will be 4, 3, 2, and 1 for each succeeding year. Year 1 2 3 4 Depreciation Rate Fraction 4/10 3/10 2/10 1/10 Depreciation Rate Decimal Percent .40 40% .30 30% .20 20% .10 10%

From this chart can be seen that an asset with 4 years of useful life will depreciate 4/10 or 40% in the first year, 3/10 or 30% in the second year, and so on.

Illustration. Velasco Wholesalers purchased a delivery truck for P350,000. The truck is expected to have a useful life of five years and a trade-in value of P50,000. The computations pertinent to depreciation follow: 1. Depreciable Cost = Original Cost Salvage Value Depreciable Cost = P350,000 P50,000 = P300,000 2. Year 1: SYD depreciation rate fraction = Years of useful life remaining n(n+1) 2 SYD depreciation rate fraction = Years of useful life remaining 5(5+1) 2 SYD depreciation rate fraction = 5__ 15 The depreciation rate fraction for year 1 is 5/15. The depreciation fractions for the remaining years will have the same denominator, 15, which is the sum of the digits of 5. Only the numerators will change, in descending order. The depreciation fractions for the remaining years are 4/15, 3/15, 2/15 and 1/15. Note How accelerated this SYD method is: 5/15 or 1/3 of the asset (33.3%), is allowed to be written off in the first year. This is compared to only 1/5 (20%) per year using the straight-line method. 3. Annual Depreciation = Depreciable Cost x Depreciation Rate Fraction Annual Depreciation = (year 1) = P300,000 x 5/15 = P100,000 Annual Depreciation = (year 2) = P300,000 x 4/15 = P 80,000 4. Delivery Truck SYD Depreciation Schedule End of Depreciable Depreciation Annual Accumulated Year Cost x Rate Fraction = Depreciation Depreciation 1 2 3 4 5 P300,000 300,000 300,000 300,000 300,000 5/15 4/15 3/15 2/15 1/15 P100,000 80,000 60,000 40,000 20,000 P100,000 180,000 240,000 280,000 300,000

Book Value (new) P350,000 250,000 170,000 110,000 70,000 50,000

Declining Balance This method is another accelerated depreciation method. Declining-balance methods are significantly different from the other methods of depreciation because the estimated salvage value is not subtracted from the original cost when computing depreciation. In addition, the computed depreciation rate is applied to a declining balance rather than to a constant depreciable cost. This method uses multiple of the straight-line rate to calculate depreciation. The most frequently used multiples are 1.25, 1.50, and 2.00. When 1.25 is used, it is known as the 125% declining balance, when 1.50 is used, it is known as the 150% declining balance. When 2.00 is the multiple, the method is known as the doubledeclining balance. To calculate the declining-balance rate, the straight-line rate is first determined by dividing 1 by the number of years of useful life, then multiplying the result by the appropriate declining-balance multiple. For example, when using the double-declining balance, an asset with useful life of 4 years would have a straight-line rate of 25% per year (1 4 = = 25%). This rate is then multiplied by the declining-balance multiple 2, to get 50%, the double-declining rate. The following formula should be used for this calculation:

Declining Balance Rate =

1 _____ Useful Life

Multiple

To further accelerate the depreciation, this declining-balance rate is applied to the original cost of the asset. Salvage value is not considered until the last year of depreciation. When preparing a depreciation schedule using the declining-balance method, the depreciation stops when the book value of the asset reaches the salvage value. An asset cannot be depreciated below the salvage value. Illustration. Rose Shipping bought a forklift for P200,000. It is expected to have a five-year life and a residual value of P20,000. Prepare the depreciation schedule for this asset using the double-declining balance method. 1. Declining Balance Rate = 1___ Useful Life 1 5 x 2 x Multiple

Declining Balance Rate

= .20 x 2 = .40 = 40%

2. Depreciation for the Year = Beginning Book Value x Declining-Balance Rate Depreciation (year 1) = 200,000 x .40 = P80,000 3. Ending Book Value =Beginning Book Value Depreciation for the Year Ending Book Value (year 1) = 200,000 80,000 = P120,000 Repeat steps 2 and 3 for years 2, 3, 4 and 5. 4. In year 5, although the calculated depreciation is P10,368 (P25,920 x .4), the allowable depreciation is limited to P5,920 (P25,920 P20,000), because the book value has reached the P20,000 residual value. At this point, the depreciation is complete. Forklift Double-Declining Balance Depreciation Schedule End of Year 1 2 3 4 5 Beginning Book Value P200,000 120,000 72,000 43,200 25,920 Depreciation Rate 40% 40% 40% 40% 40% Depreciation for the Year P80,000 48,000 28,800 17,280 5,920* Accumulated Depreciation P 80,000 128,000 156,800 174,080 180,000 Ending Book Value (new) P200,000 120,000 72,000 43,200 25,920 20,000

*Maximum allowable to reach salvage value. Depreciation for Partial Years Property and equipment are acquired when needed. These assets are rarely placed in service at the beginning of a period nor disposed of at the last day of a period. Thus, the first and last year of use may present the problem of determining depreciation for partial years. Some compute the exact amount of depreciation of each fractional period, and others apply an accounting policy convention. Illustration. On April 1, 2009, Abellana Heavy Equipments bought a backhoe for P500,000. The estimated salvage value of this equipment is P80,000. Its estimated useful life is 10 years. The entity follows a calendar year reporting cycle. The full year depreciation should be computed first. Depreciable cost is P420,000 and estimated useful life is 10 years. Annual depreciation is P42,000. The asset is used only 9/12 of the year. The depreciation for the partial year is P31,500 or P42,000 x 9/12.