Inventories
I. Definition – 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 the rendering of
services
II. Classes of Inventories
B. Trading Concern – merchandise inventory
C. Manufacturing Concern – finished goods, goods in process, raw materials, manufacturing or factory
supplies
III. Goods to be Included in Inventory Account
1. goods to which company has legal title
2. goods purchased on installment contract, even if legal title will pass only upon full payment
of selling price
3. goods on consignment (company is consignor); freight and other handling charges on goods
on consignment are part of cost of goods consigned
IV. Balance Sheet Presentation
presented as one line in the B/S (current assets section); breakdown/details are shown in the notes
V. Accounting for Inventories
A. Periodic and Perpetual Systems
Inventory shortage – usually closed to CGS unless abnormal or material, in which case is presented
as other expense
B. Trade discounts
C. Cash discounts
Gross and net method for recording purchases with cash discounts
VI. Inventory Cost
1. Cost of inventories is determined using either FIFO or weighted average
2. Cost of inventories that are not ordinarily interchangeable and inventories segregated for specific
projects is determined using specific identification.
3. Cost of inventories includes
(a) cost of purchase – purchase price, import duties and taxes, freight, handling and other goods
directly attributable to the acquisition of finished goods, materials and services; may not include
foreign exchange differences
(b) cost of conversion – direct labor, fixed and variable production overhead
(c) other cost incurred in bringing the inventories to their present location and condition –
borrowing cost is included if inventories are considered qualifying assets (i.e., require a substantial
period of time to bring them to a salable condition)
Excluded from cost of inventories: (a) abnormal waste, (b) storage costs, (c) administrative
overhead, and (d) selling costs
VII. Cost Formulas
A. FIFO
Inventory in the balance sheet is valued at most recent costs
Ending inventory cost under FIFO periodic and FIFO perpetual is the same
No proper matching in the income statement
B. Weighted average
Inventory cost = total cost of GAS ÷ total units available for sale
Under perpetual, requires computation of a moving average cost
C. Specific Identification
Used for inventories that are segregated for a specific project and inventories that are not
ordinarily interchangeable
VIII. Inventory Measurement in the Balance Sheet (see Attachment A)
Lower of cost or net realizable value on an item by item basis (NRV = estimated selling price in the
ordinary course of business less estimated cost of completion and the estimated cost necessary to
make the sale); similar or related items may be grouped for purposes of applying LCNrv
Application of LCNrv Rule
A. Direct method – loss on inventory writedown is included in CGS
Inventory is valued at LCNrv immediately
B. Allowance method – loss on inventory writedown is accounted for separately
Ending inventory is valued at cost; a separate allowance account is set up for the
writedown
Loss (or gain on reversal) on inventory writedown is added to (deducted from) CGS
Important Note: CGS is the same regardless of method used.
IX. Inventory Estimation
A. Gross Profit Method
Basic Relationship: Beginning Inventory xx
Add: Net Purchases xx
Freight-in xx___
Goods available for Sale xx
Less: Ending inventory* xx___
Cost of goods sold xx
2
* estimated using gross profit rate based on (1) sales or (2) cost
Example:
GPR based on sales GPR based on cost
Net Sales** 100% 140%
CGS 60% 100%
Gross Profit 40% 40%
** excludes sales discount and sales allowance
B. Retail Method1
Basic Formula
GAS @ retail or selling price xx
Less: Net sales (gross sales less sales returns) _xx__
EI @ selling price xx
Multiply by cost ratio*** __xx__
EI @ cost xx
=====
*** cost ratio = GAS at cost ÷ GAS at selling price/retail (except for FIFO retail – see below)
Three Approaches (in computing cost ratio)
(1) Conservative or conventional or LCM approach – considers only net markup (net markup = markup less
markup cancellation) in computing GAS @ retail.
(2) Average cost approach – considers both net markup and net markdown (net markdown = markdown
less markdown cancellation) in computing GAS @ retail
(3) FIFO – similar to average cost but markup and markdown adjustments are applied only to purchases
during the year; the cost ratio is based only on purchases (cost ratio = purchases @ cost ÷ purchases @
retail)
Terminology
a. initial markup – original markup on the cost of goods
b. original retail – the sales price at which the goods are first offered for sale
c. additional markup – increase in sales price above the original sales price
d. markup cancellation – decrease in sales price that does not decrease the sales price below the original
sales price (i.e., cancellation only of additional markup)
e. net additional markup or net markup = markup less markup cancellation
f. markdown – decrease in sales price below the original sales price
g. markdown cancellation – increase in sales price that does not increase the sales price above the original
sales price (i.e., cancellation only of markdown)
h. net markdown – markdown less markdown cancellation
i. maintained markup – difference between cost and sales price after adjustment for all the above items;
a.k.a. “markon”
1
This section is from Valix and Peralta, Financial Accounting Vol. 1
3
Treatment of other items
a. purchase discount and purchase allowance – deducted from purchases at cost only
b. purchase return – deducted from purchases at cost and at retail
c. freight in – added to purchases at cost only
d. departmental transfer in or debit – addition to purchases at cost and at retail
e. departmental transfer out or credit – deduction from purchases at cost and at retail
f. sales discount and sales allowance – ignored
g. sales return – deducted from sales
h. employee discounts – added to sales
i. normal shortage, shrinkage, spoilage, breakage – deducted from GAS @ retail
j. abnormal shortage, shrinkage, spoilage, breakage – deducted from GAS @ cost and GAS @ retail
Illustrations
Cost Retail
Beginning inventory 180,000 250,000
Net purchases 1,020,000 1,575,000
Additional markup 200,000
Markup cancellation 25,000
Markdown 140,000
Markdown cancellation 15,000
Sales 1,450,000
Sales return 50,000
Sales allowance 10,000
Sales discount 20,000
Employee discount 40,000
Spoilage and breakage 35,000
Conservative and Average Cost Approaches
Cost Retail
Beginning inventory 180,000 250,000
Net purchases 1,020,000 1,575,000
Additional markup 200,000
Markup cancellation (25,000)
GAS – conservative 1,200,000 2,000,000
Cost ratio = 60%
Markdown (140,000)
Markdown cancellation 15,000
GAS – average 1,200,000 1,875,000
Cost ratio = 64%
Less: Sales 1,450,000
Sales returns (50,000)
Emp discount 40,000
Spoilage/breakage 35,000 1,475,000
EI at retail 400,000
EI at conservative cost 240,000
4
EI at average cost 256,000
FIFO Approach
Cost Retail
Beginning inventory 180,000 250,000
Net purchases 1,020,000 1,575,000
Additional markup 200,000
Markup cancellation (25,000)
Markdown (140,000)
Markdown cancellation 15,000
1,020,000 1,625,000
GAS 1,200,000 1,875,000
Cost ratio = 62.8%
Less: Sales 1,450,000
Sales returns (50,000)
Emp discount 40,000
Spoilage/breakage 35,000 1,475,000
EI at retail 400,000
EI at FIFO cost 251,077
X. Analysis of Sales and Inventory
Inventory turnover = CGS ÷ average inventory
Days in inventory = 365 ÷ inventory turnover or Average inventory ÷ CGS per day
Receivables turnover = Sales ÷ Average Receivables
Days in receivables = 365 ÷ receivables turnover or Average receivables ÷ Daily sales
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Attachment A
Lower of Cost or Net Realizable Value
Illustration:
Assume the inventory records show the following data on December 31, 2014
Unit Total Total
Units cost NRV cost NRV LCNrv
[a] [b] [c] [a] x [b] [a] x [c]
Product X 1000 11 10 11000 10000 10000
Product Y 3000 23 25 69000 75000 69000
Product Z 2000 30 32 60000 64000 60000
140000 149000 139000
In accordance with Phil. GAAP, the inventory must be measured at lower of cost or net realizable value on
an item-by-item basis (or by grouping similar items). In this case, the Dec 31, 2014 balance sheet should
report inventories at P139,000.
Direct Method
A. Periodic system
Inventory 139,000
Income summary 139,000
B. Perpetual system
Loss on inventory writedown 1,000 added to CGS
Inventory 1,000
Allowance Method
A. Periodic system
Inventory 140,000
Income summary 140,000
Loss on inventory writedown 1,000 added to CGS
Allowance for decline in value
of inventory 1,000 shown in the B/S as a deduction from inventory
at cost
B. Perpetual system
Loss on inventory writedown 1,000 added to CGS
Allowance for decline in value
of inventory 1,000 shown in the B/S as a deduction from inventory
at cost
6
Thus, under direct method, inventory in the B/S is valued at P139,000.
Under the allowance method, inventory is shown as follows:
Inventory at cost P140,000
Less: Allowance for decline in value of inventory 1,000
-------------
P139,000
=======
Assume the following additional data as of Dec 31, 2015:
Ending inventory, at cost P100,000
Ending inventory, at LCNrv (item-by-item basis) P 96,000
Net purchases P220,000
Direct Method
A. Periodic system
Inventory 96,000
Income summary 96,000
B. Perpetual system
Loss on inventory writedown 4,000 added to CGS
Inventory 4,000
Allowance Method
A. Periodic system
Inventory 100,000
Income summary 100,000
Loss on inventory writedown 3,000** added to CGS
Allowance for decline in value
of inventory 3,000 shown in the B/S as a deduction from inventory
at cost
** because the allowance account has an existing balance of P1,000. Thus, we need to increase it
only by P3,000
B. Perpetual system
Loss on inventory writedown 3,000 added to CGS
Allowance for decline in value
of inventory 3,000 shown in the B/S as a deduction from inventory
at cost
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Thus, under direct method, inventory in the B/S is valued at P96,000.
Under the allowance method, inventory is shown as follows:
Inventory at cost P100,000
Less: Allowance for decline in value of inventory 4,000
-------------
P 96,000
=======
Computation of Cost of Goods Sold for 2015
Direct Method
A. Periodic
Beginning inventory P139,000
Net Purchases 220,000
--------------
GAS P359,000
Ending inventory ( 96,000)
--------------
CGS P263,000
========
B. Perpetual
CGS before adjustment for LCNrv P259,000
Add: Loss on writedown of inventory 4,000
-------------
Adjusted CGS P263,000
=======
Allowance Method
A. Periodic
Beginning inventory P140,000
Net Purchases 220,000
--------------
GAS P360,000
Ending inventory ( 100,000)
--------------
CGS P260,000
Add: Loss on inventory writedown 3,000
--------------
Adjusted CGS P263,000
========
B. Perpetual
8
CGS before LCNrv adjustment P260,000
Add: Loss on writedown of inventory 3,000
-------------
Adjusted CGS P263,000
=======
Source:
Notes from Prof. Florendo
