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LECTURE NOTES
Nature of inventories Cost should include all
costs of purchase (including taxes, transport, and
Inventories include:
handling) net of trade discounts received
Assets held for sale in the ordinary course of
costs of conversion (including fixed and variable
business (finished goods),
manufacturing overheads) and
Assets in the production process for sale in the
other costs incurred in bringing the inventories to
ordinary course of business (work in process), and
their present location and condition
Materials and supplies that are consumed in
production (raw materials).
Inventory cost should not include:
abnormal waste
storage costs
Whose inventory is it?
administrative overheads unrelated to production
Goods in transit selling costs
foreign exchange differences arising directly on the
Shipping terms determine when title to goods passes recent acquisition of inventories invoiced in a foreign
to the purchaser. currency
a. FOB (free on board) shipping point—title passes to interest cost when inventories are purchased with
the buyer with the loading of goods at the point of deferred settlement terms.
shipment.
b. FOB destination—legal title does not pass until the Net realizable value is the estimated selling price in the
goods are received by the buyer. ordinary course of business less the estimated costs of
Goods shipped FOB shipping point belong to the buyer completion and the estimated costs necessary to make the
while they are in transit and should normally be sale.
included in the buyer’s inventory while in transit.
Goods shipped FOB destination belong to the seller Fair value is the amount for which an asset could be
while in transit and are normally included in the seller’s exchanged, or a liability settled, between knowledgeable,
inventory. willing parties in an arm’s length transaction.
Goods on consignment
Goods held by the dealer (consignee) for which title is Other measurement bases
held by the shipper (consignor). Repossessed merchandise–fair value or best approximation
Consigned goods are included in the inventory of the of fair value
consignor.
Trade-in inventory–net realizable value minus normal
Conditional sales, installment sales, and repurchase profit margin
agreements
Commodities of brokers-traders–fair value less costs to
If title to the goods is retained by the seller, the seller sell. Broker-traders are those who buy or sell commodities
may report as an asset the cost of the goods less the for others or on their own account.
purchaser’s equity in the goods such as established by
Agricultural, forest and mineral products–net realizable
collections.
value
Generally however, in the usual case where the
possibilities of default or return are low, the seller, in Agricultural produce at the point of harvest–fair value less
anticipation of contract completion and ultimate costs to sell
passing of title, will recognize the transaction as a
regular sale and remove the goods from reported
inventory at the time of sale. Inventory cost formulas
Repurchase agreements result in no sale being
The purpose of an inventory valuation method is to
recorded; the inventory is thus not removed from the
allocate the total inventory cost of good available for sale
books, and instead the “seller” records a liability for
during the period between cost of goods sold and ending
the proceeds of the “sale”, which more accurately in
inventory.
substance is a short-term loan secured by inventory as
collateral.
Specific identification
Required for inventories that are not ordinarily
Measurement of inventories (PAS 2) interchangeable and goods or services produced and
segregated for specific projects.
Inventories are required to be stated at the lower of cost
Using the specific identification method, the original
and net realizable value (NRV).
cost of each item is identified, resulting in actual costs
being accumulated for the specific items on hand and
sold.
Page 1 of 9
PROFESSIONAL REVIEW and TRAINING CENTER, INC.
Though theoretically attractive and useful when each First- in, first- out method (FIFO)
inventory item is unique and has a high cost, it is
The first goods purchased are the first goods sold.
frequently not economically feasible (even if taking
Using the FIFO method, the accountant computes the
into account advances in technology), particularly
cost of goods sold and ending inventory as if the first
where inventory is composed of a great many items or
items purchased are the first to be sold, leaving the
identical items acquired at different times and at
most recently purchased items in inventory.
different prices.
This often matches the physical flow of goods.
It is subject to manipulation, as seller has the flexibility
FIFO affords little opportunity for profit manipulation.
of selectively choosing specific items of higher/lower-
FIFO best approximates the current replacement value of
costing inventory depending on particular income goals
ending inventory.
at the time of sale.
It is the least common method observed in practice.
Comparison of methods: cost of goods sold and ending
inventory
Average cost method The average cost method:
Differs from the other methods in that no assumption
This method assigns the same average cost to each
is made about the sale of specific units.
unit.
Rather, all sales are assumed to be of the “average”
Based on the assumption that goods sold should be
unit at the average cost per unit.
charged at an average cost, with the average being
The gross profit margin tends to follow a similar
weighted by the number of units acquired at each
pattern to FIFO in response to changing prices.
price.
Generally provides inventory values similar to FIFO
The average cost method can be supported as realistic
values, since average costs are heavily influenced by
and as paralleling the physical flow of goods,
current costs.
particularly where there is an intermingling of identical
inventory units.
FIFO:
It provides the same cost for similar items of equal
In a period of rising prices, matches oldest low-cost
utility.
inventory with rising sales prices, thus expanding the
It does not permit profit manipulation.
gross profit margin.
Its limitation is that inventory values may lag
In a period of declining prices, oldest high-cost
significantly behind current prices in periods of rapidly
inventory is matched with declining sales prices, thus
rising or falling prices.
narrowing the gross profit margin.
Inventories are reported on the balance sheet at or
near current costs.
Specific identification:
Can produce any variety of results depending on which
particular units are selected for shipment.
REQUIRED:
Compute for the closing inventory under each of the following pricing methods? (Round unit costs to two decimal places.)
1. FIFO - Periodic
2. FIFO - Perpetual
3. Weighted average - Periodic
4. Weighted average – Perpetual (Moving average)
SOLUTION:
FIFO – Periodic
From November 15 purchases (1,000 units x P16.00) - P16,000
From June 22 purchases (880 units x P15.00) - 13,200
Total P29,200
FIFO – Perpetual
Average – Periodic
Total cost (1,880 units x P14.92) - P28,050
Accounting for inventory write down Using the perpetual system, entries for revenue, cost
of goods sold, and the reduction of inventory are
The cost of inventories may not be recoverable if:
recorded for each sales transaction.
those inventories are damaged
A continuous record of quantities in inventory and
they have become wholly or partially obsolete
items sold is maintained.
their selling prices have declined
Shrinkage is a term related to any observed
the estimated costs of completion or the estimated
differences, attributable to a variety of possible
costs to be incurred to make the sale have increased
factors, between the inventory quantity at year-end as
The practice of writing inventories down below cost to net
indicated by the perpetual record and the actual
realizable value is consistent with the view that assets
quantity on hand as determined by a physical
should not be carried in excess of amounts expected to be
inventory.
realized from their sale or use.
Benefits of a perpetual system.
Inventories are usually written down to net realizable value 1. Provides a continuous check and control
item by item. mechanism on inventory.
2. Facilitates purchasing and production planning
Materials and other supplies held for use in the production 3. Ensures adequate on-hand inventories
of inventories are not written down below cost if the 4. Helps identify and measure the magnitude of
finished products in which they will be incorporated are inventory shrinkage.
expected to be sold at or above cost. However, when a 5. Advances in, and cost reductions relating to,
decline in the price of materials indicates that the cost of technology have made perpetual systems much
the finished products exceeds net realizable value, the more feasible, and it’s a good thing – today’s fast-
materials are written down to net realizable value. In such paced, competitive business environment
circumstances, the replacement cost of the materials may magnifies the importance of a perpetual system’s
be the best available measure of their net realizable value. benefits.
When the circumstances that previously caused inventories
to be written down below cost no longer exist or when
there is clear evidence of an increase in net realizable Purchase commitments
value because of changed economic circumstances, the A lock on the inventory purchase price in advance. An
amount of the write-down is reversed (i.e. the reversal is executory contract (an exchange of promises about
limited to the amount of the original write-down) so that future actions).
the new carrying amount is the lower of the cost and the
revised net realizable value. No journal entry is required to record an asset and
liability at the commitment date.
Recognition as an Expense
However, when price declines take place subsequent to
When inventories are sold, the carrying amount of those the commitment and it is outstanding at the end of an
inventories shall be recognized as an expense in the period accounting period, the loss is recorded just as losses
in which the related revenue is recognized. The amount of with goods on hand are recognized (i.e., as with LCM,
any write-down of inventories to net realizable value and in the period in which the inventory price decline took
all losses of inventories shall be recognized as an expense place).
in the period the write-down or loss occurs. The amount
Acquisition of the goods in a subsequent period is also
of any reversal of any write-down of inventories, arising
recorded.
from an increase in net realizable value, shall be
1. Purchases are recorded at current market value.
recognized as a reduction in the amount of inventories
2. Difference between current market value of goods
recognized as an expense in the period in which the
and total amount owed per the purchase
reversal occurs.
commitment is reflected by the removal of the
estimated loss on purchase commitments account
Some inventories may be allocated to other asset
(a balance sheet account created above).
accounts, for example, inventory used as a component of
self-constructed property, plant or equipment. Inventories Current loss recognition is not appropriate when:
allocated to another asset in this way are recognized as an 1. Commitments can be cancelled,
expense during the useful life of that asset. 2. Commitments provide for price adjustment,
3. Hedging transactions prevent losses, or
Inventory systems 4. Declines do not suggest reductions in sales prices.
Periodic inventory system If, prior to delivery, the market price increases, the
estimated loss on purchase commitments account is
An inventory system in which only revenue is recorded
reduced and a gain is recorded, though such
each time a sale occurs; the inventory balance is
“recovery” can only be recognized to the extent of the
determined by a periodic physical inventory.
original loss recorded.
Using the periodic system, items must be physically
counted to determine quantities on hand.
Quantities of items sold are determined indirectly by
Using inventory information for financial analysis
subtracting the units on hand from the sum of the
units in the beginning inventory and units purchased Inventory balances are often used to measure a company’s
during the year. efficiency in using that asset to generate sales.
Perpetual inventory system Inventory turnover evaluates the inventory position and
the appropriateness of its size (cost of goods sold/ average
An inventory system which provides a continuous
inventory).
summary of goods on hand.
What peso amount should be reported for the cost of Solution guide for question #9:
goods sold under the net method of recording
purchases? Assume that there was no beginning Unit
inventory. Date Description Units Cost Total Cost
a. P180,000 c. P176,800 Dec. 1 Balance 350 820 287,000
b. P177,120 d. P176,400
43 850 36,550
C8 Pr8-76 Kieso TB, 11th ed-AMP
393 823 323,550
Use the following information for the next two questions. Dec. 2 Sale (300) 823 (246,900)
Balance 93 823 76,650
Transactions for the month of June were:
Sales
Purchases Sales Dec. 3 returns 5 823 4,115
June 1 400 @ P3.20 June 2 300 @ P5.50 Balance 98 823 80,765
(balance)
Dec. 9 Purchase 55 910 50,050
3 1,100 @ 3.10 6 800 @ 5.50
7 600 @ 3.30 9 500 @ 5.50 Balance 153 855 130,815
15 900 @ 3.40 10 200 @ 6.00 Dec. 13 Purchase 76 960 72,960
22 250 @ 3.50 18 700 @ 6.00 Balance 229 890 203,775
25 150 @ 6.00 Dec. 15 Sale ( 86) 890 (76,540)
Balance 143 890 127,235
6. Assuming that perpetual inventory records are kept in Purchase
pesos, the ending inventory on a FIFO basis is Dec. 16 returns ( 1) 910 ( 910)
a. P1,900 c. P2,065
Balance 142 890 126,325
b. P1,920 d. P2,100
Dec. 22 Sale ( 60) 890 (53,400)
7. Assuming that perpetual inventory records are kept in Balance 82 890 72,925
units only, the ending inventory on an average-cost Dec. 26 Purchase 72 980 70,560
basis is Balance 154 932 143,485
a. P1,980 c. P1,970
b. P1,956 d. P1,995 10. Balungao Company changed its accounting policy in
K, W & W 2009 with respect to the valuation of inventories. Up
Moving average. = 2,040 to 2009, inventories were valued using weighted-
average cost (WAC) method. In 2010 the method was
Use the following information for the next two questions. changed to first-in, first-out (FIFO), as it was
Orang Dampuan Co. wholesales bicycles. It uses the considered to more accurately reflect the usage and
perpetual inventory system. The company's reporting date flow of inventories in the economic cycle. The impact
is 31 December. At 1 December 2010, inventory on hand on inventory valuation was determined to be
consisted of 350 bicycles at P820 each and 43 bicycles at At December 31, 2008: An increase of P100,000
P850 each. During the month ended 31 December 2010, At December 31, 2009: An increase of P150,000
the following inventory transactions took place (all At December 31, 2010: An increase of P200,000
purchase and sales transactions are on credit):
The change in accounting policy increased net profit for
Dec. 02 Sold 300 bicycles for P1,200 each. 2010 by
03 Five bicycles were returned by a customer. a. P200,000 c. P450,000
They had originally cost P820 each and were b. P150,000 d. P 50,000
sold for P1,200 each.
09 Purchased 55 bicycles at P910 each. 11. The trial balance of Esplanade Company showed
13 Purchased 76 bicycles at P960 each. inventories of P164,000. The inventories include some
15 Sold 86 bicycles for P1,350 each. goods that have a production cost of P18,000. These
16 Returned one damaged bicycles to the goods have a manufacturing defect that will cost
supplier. This bicycle had been purchased on P6,000 to correct. The normal selling price for these
9 December. goods would be P25,000, but after the remedial work
22 Sold 60 bicycles for P1,250 each. they will be sold through an agent as refurbished
26 Purchased 72 bicycles at P980 each. goods at a discount of 20% on the normal selling price.
29 Two bicycles, sold on 22 December, were The agent will receive a commission of 10% of the
returned by a customer. The bicycles were reduced selling price. In relation to the defective
badly damaged so it was decided to write goods, the company will recognize a loss on inventory
them off. They had originally cost P910 each. write down of
a. P6,000 c. P1,000
8. The cost of inventory as of December 31, 2010 using b. P4,000 d. P 0
FIFO method is ACCA F7 07-08 #18C.5
a. P148,980 c. P149,890
C P A
July 1 Inventory 50,000 30,000 65,000
units at units at units at
P6.00 P10.00 P0.90
July Purchases 70,000 45,000 30,000
1-15 units at units at units at
P6.50 P10.50 P1.25
July Purchases 30,000
16-31 units at
P8.00
July Sales 105,000 50,000 45,000
1-31 units units units
July 31 Sales price
per unit P8.00 P11.00 P2.00
13. The loss on inventory write down for the month of July
is
a. P 5,650 c. P85,650
b. P13,500 d. P82,650
14. The cost of sales after loss on inventory write down for
the month of July is
a. P1,298,500 c. P1,208,000
b. P1,290,650 d. P1,022,260
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