CHAPTER 13

INVENTORY ESTIMATION

Ninia C. Pauig-Lumauan, MBA, CPA

2nd Semester 2020-2021
Lyceum of Aparri

Intermediate Accounting Part 1

 INVENTORY FINANCING AGREEMENTS
• Inventories may be acquired or sold under
various forms of financing agreements,
which may include the following:
a. Product financing agreement –a seller
sells inventory to a buyer but assume an
obligation to repurchase it at a later
date. This agreement does not result to
the transfer of control over the asset.
Therefore, the seller retains ownership
over the inventory.
Intermediate Accounting Part 1
 INVENTORY FINANCING AGREEMENTS
b. Pledge of inventory – a borrower uses
the inventory as collateral security for
a loan. This arrangement does not
result to the transfer of control over
the asset. Therefore, the borrower
retains ownership over the inventory.

Intermediate Accounting Part 1

INVENTORY FINANCING AGREEMENTS
• Loan of Inventory – an entity borrows
inventory from another entity to be
replaced with the same kind of inventory.
This arrangement results to transfer of
control over the asset. Accordingly, the
borrower includes the loaned goods in its
inventory.

Intermediate Accounting Part 1

TRADE DISCOUNTS AND CASH DISCOUNTS

• Trade discounts are deductions from the

list or catalog price in order to arrive at the
invoice price which is the amount actually
charged to the buyer. Thus, trade
discounts are not recorded.
• The purpose of trade discounts is to
encourage trading or increase sales. Trade
discounts also suggest to the buyer the
price at which the goods may be resold.
Intermediate Accounting Part 1
 TRADE DISCOUNTS AND CASH DISCOUNTS

• Cash discounts are deductions from the

invoice price when payment is made
within the discount period. The purpose
of cash discounts is to encourage prompt
payment. Cash discounts are recorded as
purchase discount by the buyer and sales
discount by the seller.

Intermediate Accounting Part 1

TRADE DISCOUNTS AND CASH DISCOUNTS

• Purchase discount is deducted from

purchases to arrive at net purchases and
sales discount is deducted from sales to
arrive at net sales revenue.

Intermediate Accounting Part 1

 ILLUSTRATION
• The list price of a merchandise purchased
is P 500,000 less 20% and 10%, with
credit terms of 5/10, n/30. This means
that trade discounts are 20% and 10%,
and the cash discount is 5% if payment is
made in 10 days.
• The full payment of the invoice is paid if
the payment is made after 10 days and
within the credit period of 30 days.
Intermediate Accounting Part 1
 ILLUSTRATION
List Price 500,000
First Trade Discount (20% x 500,000) (100,000)
Total 400,000
Second Trade Discount (10% x 400,000) 40,000
Invoice Price 360,000
Cash Discount (5% x 360,000) 18,000
Payment Within the Discount Period 342,000
=======
JOURNAL ENTRIES:
Purchases 360,000
Accounts Payable 360,000
To record the purchases on account.
Accounts Payable 360,000
Cash 342,000
Purchase Discount 18,000
To record payment within the discount period.

Intermediate Accounting Part 1

 METHODS OF RECORDING PURCHASES

1. Gross Method – Purchases and

accounts payable are recorded at gross.
2. Net Method - Purchases and accounts
payable are recorded at net.
• The cost measured under the net
method represents the cash equivalent
price on the date of payment and
therefore the theoretically correct
historical cost.
Intermediate Accounting Part 1
 GROSS METHOD VS NET METHOD
• However, in practice, most entities record
purchases at gross invoice amount.
• Technically, the gross method violates the
matching principle because discounts are
recorded only when taken or when cash is
paid rather than when purchases that give
rise to the discount are made.
• Moreover, this procedure does not
allocate discounts taken between goods
sold and goods on hand.
Intermediate Accounting Part 1
 GROSS METHOD VS NET METHOD

• Despite its theoretical shortcomings, the

gross method is supported on practical
grounds.
• The gross method is more convenient
than the net method from a bookkeeping
standpoint. Moreover, if applied
consistently over time, it usually
produces no material errors in the
financial statements.
Intermediate Accounting Part 1
 ILLUSTRATION
GROSS METHOD NET METHOD
1. Purchases 200,000 1. Purchases 196,000
Accounts 200,000 Accounts 196,000
Payable Payable
To record purchase on account, 2/10,n/30 To record purchase on account, 2/10,n/30
2. Accounts 200,000 2. Accounts 196,000
Payable Payable
Cash 196,000 Cash 196,000
Purchase 4,000 To record payment within the discount
Discount period.
To record payment within the discount 3. Accounts 196,000
period. Payable
3. Accounts 200,000 Purchase 4,000
Payable Discount Lost
Cash 200,000 Cash 200,000
To record payment beyond the discount To record payment beyond the discount
period. period.

Intermediate Accounting Part 1

 ILLUSTRATION
NET METHOD
4. Purchase Discount Lost (Other Expense) 4,000
Accounts Payable 4,000
To record discount lost at the end of the accounting period and no payment is
made and the discount period has expired.

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.
Intermediate Accounting Part 1
 COST OF PURCHASE
• The cost of purchase of inventories
comprises the purchase price, import
duties and irrevocable 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.
Intermediate Accounting Part 1
 COST OF PURCHASE
• The cost of purchase shall not include
foreign exchange differences which arise
directly from the recent acquisition of
inventories involving foreign currency.
• Moreover, when inventories are
purchased with deferred settlement
terms, the difference between the
purchase price for normal credit terms and
the amount paid is recognized as interest
expense over the period of financing.
Intermediate Accounting Part 1
 COST OF CONVERSION

• The cost of conversion of inventories

includes cost directly related to the units of
production such as direct labor. It also
includes a systematic allocation of fixed and
variable production overhead that is incurred
in converting materials into finished goods.
• Fixed production overhead is the indirect
cost of production that remains relatively
constant regardless of the volume of
production.
Intermediate Accounting Part 1
 COST OF CONVERSION
• Examples are depreciation and
maintenance of factory building and
equipment, and the cost of factory
management and administration.
• Variable production overhead is the
indirect cost of production that varies
directly with the volume of production.
Examples are indirect labor and indirect
materials.
Intermediate Accounting Part 1
ALLOCATION OF FIXED PRODUCTION OVERHEAD

• The allocation of fixed production overhead

to the cost of conversion is based on the
normal capacity of the production
facilities.
• Normal capacity is the production expected
to be achieved on average over a number
of periods or seasons under normal
circumstances taking into account the loss
of capacity resulting from planned
maintenance. Intermediate Accounting Part 1
ALLOCATION OF FIXED PRODUCTION OVERHEAD

• The amount of fixed overhead allocated

to each unit of production is not
increased as consequence of low
production or idle plant.
• Unallocated fixed overhead is recognized
as expense in the period in which it is
incurred.

Intermediate Accounting Part 1

ALLOCATION OF VARIABLE PRODUCTION OVERHEAD

• Variable production overhead is allocated

to each unit of production on the basis of
the actual use of the production facilities.
• A production process may result in more
than one product being produced
simultaneously. This is the case, for
example, when joint products are
produced or where there is a main
product and a by-product.
Intermediate Accounting Part 1
ALLOCATION OF VARIABLE PRODUCTION OVERHEAD

• When the costs of conversion are not

separately identifiable, they are allocated
between the products on a rational and
consistent basis, for example, on the
basis of the relative sales value of each
product. Most by-products by their
nature are not material.

Intermediate Accounting Part 1

 ALLOCATION OF VARIABLE PRODUCTION
OVERHEAD
• By products are measured at net
realizable value and this value is
deducted from the cost of the main
product.

Intermediate Accounting Part 1

 OTHER COST
• Other cost is included in the cost of
inventories only to the extent that it is
incurred in bringing the inventories to their
present location and condition. For
example, it may be appropriate to include
the cost of designing product for specific
customers in the cost of inventories.
• However, the following costs are excluded
from the cost of inventories and recognized
as expenses in the period when incurred:
Intermediate Accounting Part 1
 OTHER COST

a. Abnormal amounts of wasted materials,

labor and other production costs.
b. Storage costs, unless these costs are
necessary in the production process
prior to a further production stage.
Thus, storage costs on goods in process
are capitalized but storage costs on
finished goods are expensed.

Intermediate Accounting Part 1

 OTHER COST
c. Administrative overheads that do not
contribute to bringing inventories to
their present location and condition.
d. Distribution or selling costs.

Intermediate Accounting Part 1

 COST OF INVENTORIES OF A SERVICE
PROVIDER
• The cost of inventories of a service
provider consists primarily of the labor
and other costs of personnel directly
engaged in providing the service,
including supervisory personnel and
attributable overhead.
• The inventories of a service provider may
simply be described as work in progress.
Intermediate Accounting Part 1
 COST OF INVENTORIES OF A SERVICE
PROVIDER
• Labor 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.

Intermediate Accounting Part 1

 INVENTORY ESTIMATION
• There may be instances where the value
of inventories must be estimated, such as
when it is not practicable to take a
physical count. For example, in the
interest of timeliness and cost
consideration, an entity may elect to rely
on estimates of inventories at interim
dates. Another instance is when records
of inventories are incomplete and
inventories must be approximated.
Intermediate Accounting Part 1
 INVENTORY ESTIMATION
• Estimates are allowed under PAS 2 only if
they approximate the cost. Generally,
inventory estimation is made only for
interim reporting. For annual reporting,
physical count of inventories is more
appropriate.
• The cost of inventories may be estimated
using either (a) gross profit method or
the (b) retail method.
Intermediate Accounting Part 1
 GROSS PROFIT METHOD
• Under the Gross Profit Method, gross
profit is assumed to be relatively constant
from period to period. Thus, the gross
profit rate (GPR) is used to determine the
cost ratio which is turn is used to estimate
the inventory and the cost of goods sold.
• Gross profit rate can be expressed as a
percentage (a) based on sales or (b)
based on cost of goods sold.
Intermediate Accounting Part 1
 GROSS PROFIT METHOD
• Gross profit rate based on sales is
computed by dividing gross profit by the
net sales, while gross profit based on
cost is computed by dividing gross profit
by the cost of goods sold.
• A GPR based on cost can be translated to
GPR based on sales (and vice versa).

Intermediate Accounting Part 1

 GROSS PROFIT METHOD
• EXAMPLE:
GPR Based GPR Based
on Sales on Cost
Net Sales 1,000 (200 Gross (200 Gross
Cost of Goods Sold (800) Profit/ 1,000 Profit/ 800
Gross Profit 200 Net sales) Cost of
vvv Goods Sold)
= 20% = 25%

Intermediate Accounting Part 1

 NET SALES

• For purposes of inventory estimation,

only sales returns are deducted from
gross sales when computing for net
sales. Sales discounts and allowances
are not deducted because these do not
affect the physical inventory of goods.
Sales returns, on the other hand, affect
the physical inventory of goods because
goods are physically returned to the
seller.

Intermediate Accounting Part 1

ESTIMATING INVENTORIES UNDER THE
GROSS PROFIT METHOD
ACCOUNTS PAYABLE
XXX Beg. Balance
Xxx Net Purchases
Payments to Suppliers xxx ____
Ending Balance xxx
===

INVENTORY
Beg Balance xxx
Net Purchases xxx
Freight In xxx _xxx_ Cost of Goods Sold
xxx Ending Balance
===

Intermediate Accounting Part 1

ESTIMATING INVENTORIES UNDER THE GROSS
PROFIT METHOD
• The formula below is derived from the
Inventory T-account above:
Inventory Beginning xxx
Net Purchases xxx
Freight In xxx
Total Goods Available for Sale xxx
Inventory, End (xxx)
Cost of Goods Sold xxx
===
Intermediate Accounting Part 1
ACCOUNTS OF A MANUFACTURING ENTITY

• The inventory accounts of a

manufacturing entity include Raw
Materials, Work In Process and Finished
Goods. The relationships between
theses accounts and Accounts Payable
are depicted in the following T-accounts.

Intermediate Accounting Part 1

ACCOUNTS OF A MANUFACTURING ENTITY
ACCOUNTS PAYABLE RAW MATERIALS
XXX Beg. Balance Beg Balance xxx
Xxx Net Purchases Net Purchases xxx
Payments to Freight In xxx Xxx Raw materials
Suppliers xxx ____ issued to
___ ___ Production
Ending
Balance xxx
=== Xxx Ending Balance
===

Intermediate Accounting Part 1

 ACCOUNTS OF A MANUFACTURING
ENTITY
WORK IN PROCESS FINISHED GOODS
Beginning Balance xx Beginning
Raw Materials Issued Cost of Balances xx
To Production xx Goods Cost of Goods Cost of Goods
Xx Manufactured Manufactured xx Xx Sold
Direct Labor xx Xx Ending Balance
Production Overhead xx ____ Total Goods
Total Goods Put Xx Ending Balance Available for
Into Process xx Sale xx Xx
== == ==

Intermediate Accounting Part 1

 ACCOUNTS OF A MANUFACTURING
ENTITY
• The formula below is derived from the T-
accounts above:
Raw Materials Beginning xxx
Purchases xxx
Freight In xxx
Purchase Returns & Discounts (xxx)
Total Raw Materials Available for Use xxx
Raw Materials, End (xxx)
Raw Materials Issued to Production xxx
Work In Process Beginning xxx
Direct Labor xxx
Production Overhead xxx
Total Goods Put Into Process xxx
Intermediate Accounting Part 1
ACCOUNTS OF A MANUFACTURING
ENTITY
Total Goods Put Into Process xxx
Work In Process, End (xxx)
Cost of Goods Manufactured xxx
Finished Goods, Beginning xxx
Total Goods Available for Sale xxx
Finished Goods, End (xxx)
Cost of Goods Sold Xxx
===

Intermediate Accounting Part 1

 RETAIL METHOD
• The retail method is often used in the
retail industry (e.g. supermarkets and
department stores) for measuring large
quantities of inventories with rapidly
changing items and with similar margins
and for which it is impracticable to use
other costing methods.
• The retail method is similar to the gross
profit method.
Intermediate Accounting Part 1
 RETAIL METHOD
• Actually, the gross profit method is a
variation of the retail method. The
following are peculiar to the retail
method:
a. The cost ratio is computed directly
without regard to the gross profit rate.
b. Net mark-ups and net mark-downs are
considered.

Intermediate Accounting Part 1

 NET MARK-UPS

• Net mark-ups (mark-ups less mark-up

cancellation) are net increases above the
original retail price, which are generally
caused by changes in supply and demand.
 Mark-up refers to increase above the
original retail price.
Original retail price refers to the selling
price at which the goods are first offered
for sale.
Intermediate Accounting Part 1
 NET MARKDOWNS

 Mark-up cancellation refers to decrease

in selling price that does not reduce the
selling price below the original retail
price.
• Net markdowns (markdowns less
markdown cancellations) are net
decreases below the original retail price.
 Markdowns refers to the decrease
below the original retail price.
Intermediate Accounting Part 1
 NET MARKDOWNS
 Markdown cancellation refers to increase
in selling price that does not raise the
selling price above the original retail price.
APPLICATION OF THE RETAIL METHOD
• The retail method is applied using either
the:
1. Average cost method
2. FIFO cost method

Intermediate Accounting Part 1

 APPLICATION OF THE RETAIL METHOD

• AVERAGE COST METHOD

• Under the average cost method, the
Total Goods Available for Sale at Cost
(beginning inventory plus net purchases)
is determined and divided by the Total
Goods Available for Sale at Sales Price to
come up with the cost ratio.
Cost Ratio = Total Goods Available for Sale at Cost
(Average Cost Total Goods Available for Sale at Sales Price
Method) or at Retail

Intermediate Accounting Part 1

 AVERAGE COST METHOD
• The cost ratio is then multiplied with net
sales to compute for the cost of goods
sold (much like under the gross profit
method) or multiplied with the ending
inventory at sales price or at retail to
compute for the ending inventory at cost.
 Cost of Goods Sold = Net Sales x Cost
Ratio.
 Ending Inventory at Cost = Ending
Inventory at Retail x Cost Ratio

Intermediate Accounting Part 1

 AVERAGE COST METHOD

• When determining Total Goods Available

for Sale at Sales Price, net mark-ups are
added while net markdowns are
deducted. PAS 2 requires that the cost
ratio to be used is estimating Inventory
under the retail method should be
marked down below its original retail
price.

Intermediate Accounting Part 1

 ILLUSTRATION: RETAIL METHOD
• Presented below is information
pertaining to ABC Co.
Cost Retail
Inventory, January 1 8,700 14,000
Purchases 55,300 80,300
Freight In 2,000 0
Purchase Discounts 500 0
Purchase Returns 5,200 8,600
Departmental Transfers In (Debit) 1,000 1,500
Departmental Transfers Out (Credit) 800 1,200
Mark-ups 6,000
Mark-up Cancellations 2,000

Intermediate Accounting Part 1

 ILLUSTRATION: RETAIL METHOD
Cost Retail
Markdowns 12,000
Markdown Cancellations 3,000
Abnormal Spoilage (theft & casualty loss) 5,000 7,000
Sales 43,800
Sales Returns 2,500
Sales Discounts 1,000
Employee Discounts 500
Normal Spoilage (shrinkage & breakages) 200

• Requirement: Compute for (a) Cost of Goods Sold and

(b) Ending Inventory using the Average Cost Method.

Intermediate Accounting Part 1

 ILLUSTRATION: RETAIL METHOD
• Solution:
Cost Retail
Inventory, January 1 8,700 14,000
Net Purchases (a) 51,600 71,700
Departmental Transfers In (Debit) (b) 1,000 1,500
Departmental Transfers Out (Credit) (800) (1,200)
Net Mark-ups (c) 6,000-2,000 4,000
Net Markdowns (c) 12,000-3,000 (9,000)
Abnormal Spoilage (e) (5,000) (7,000)
Total Goods Available for Sale (d) 55,500 74,000
======
Net Sales (e) (42,000)
Ending Inventory at Retail 32,000
======

Intermediate Accounting Part 1

 COMPUTATIONAL SCHEDULES
a) Net purchases are computed as the
sum of purchases and freight in less
purchase returns and discounts. Note
purchase discounts and freight in affect
only the cost column. They do not
affect the retail column.
Cost Retail
Purchases 55,300 80,300
Freight In 2,000 0
Purchase Discounts (500) 0
Purchase Returns (5,200) (8,600)
Net Purchases 51,600 71,700

Intermediate Accounting Part 1

 COMPUTATIONAL SCHEDULES
b) Departmental transfers refer to transfers of
goods between departments within an
entity.
• Departmental transfers in or debit refers to
inventory received by a department from
another department. It is added to
purchase at cost and at retail.
• Departmental transfers out or credit refers
to inventory transferred out by a
department to another department. It is
deducted from purchase at cost and at
retail.
Intermediate Accounting Part 1
 COMPUTATIONAL SCHEDULES
c) Net mark-ups is mark-ups less mark-up
cancellations. Net markdowns is
markdowns less markdown cancellations.
d) The average cost ratio is computed as
follows:
Cost Ratio = Total Goods Available for Sale at Cost
(Average Cost Total Goods Available for Sale at Sales Price
Method) or at Retail
Average Cost = 55,500
Ratio 74,000
= 75%
vvv

Intermediate Accounting Part 1

 COMPUTATIONAL SCHEDULES
e) Net Sales is computed as follows:
Sales 43,800
Sales Returns (2,500)
Employee Discounts 500
Normal Spoilage (shrinkage & 200
breakages)
Net Sales 42,000

• Note that only the Sales Returns is

deducted, all the rest are added.

Intermediate Accounting Part 1

 COMPUTATIONAL SCHEDULES
Employee discounts are special discounts
that are not recorded in the sales
discounts account but rather treated as
direct deductions from selling price.
Employee discounts are added back to
sales because these discounts decreases
sales but do not affect physical inventory.
Sales discounts should be ignored or not
deducted from gross sales.

Intermediate Accounting Part 1

 COMPUTATIONAL SCHEDULES
 Normal spoilage is generally allowed in
an entity’s pricing policies. For this
reason, it is deducted from the retail
column after calculation of the cost ratio.
• Normal spoilage is charged to cost of
goods sold, thus, it is added to sales
when computing for net sales. Normal
spoilages usually arise from shrinkage or
breakage.
Intermediate Accounting Part 1
 COMPUTATIONAL SCHEDULES

 Abnormal spoilage, on the other hand,

should be deducted from both the cost
and retail columns before the calculation
of the cost ratio, as abnormal spoilage
could distort the ratio. Abnormal
spoilage is reported as loss, separate
from cost of goods sold. Abnormal
spoilage usually arise from theft of
casualty.
Intermediate Accounting Part 1
 COMPUTATIONAL SCHEDULES
• Ending Inventory at cost is computed as
follows:
Ending Inventory at Retail (or selling price) 32,000

Multiply by Average Cost Ratio 75%

Ending Inventory at Cost 24,000

• Cost of Goods Sold is computed as

follows:
Total Goods Available for Sale at Cost 55,500

Ending Inventory at (24,000)

Cost of Goods Sold 31,500

Intermediate Accounting Part 1

 COMPUTATIONAL SCHEDULES
 Optional Reconciliation:
Total Goods Available for Sale at Cost 42,000
Multiply by Average Cost Ratio 75%
Cost of Goods Sold 31,500

• FIFO Cost Method

• The application of the FIFO cost method is
very similar to the application of the
Average Cost Method. The only difference
lies on the computation of the cost ratio.

Intermediate Accounting Part 1

 FIFO COST METHOD
• Under the FIFO cost method, the
beginning inventories at cost and at retail
are simply excluded from TGAS when
computing
Cost Ratio
for the cost ratio.
= Total Goods Available for Sale at Cost – Beginning Inventory at cost
(FIFO Cost Total Goods Available for Sale at Sales Price or at Retail – Beginning
Method) Inventory at Retail

• Using the previous illustration, the cost

ratio under the FIFO Cost method is
computed as follows:
Intermediate Accounting Part 1
 FIFO COST METHOD
Cost Ratio Total Goods Available for Sale at Cost – Beginning
(FIFO Cost Inventory at cost____________________________
Method) Total Goods Available for Sale at Sales Price or at
Retail – Beginning Inventory at Retail
FIFO Cost Ratio = 55,500 -8,700
74,000 – 14,000
= 78%
vvv

Ending Inventory are cost is computed as

follows:
Ending Inventory at Retail (or selling price) 32,000

Multiply by Average Cost Ratio 78%

Ending Inventory at Cost 24,960
Intermediate Accounting Part 1
 FIFO COST METHOD
• Cost of Goods Sold is computed as
follows:
Total Goods Available for Sale at Cost 55,500

Ending Inventory at (24,960)

Cost of Goods Sold 30,540
• Optional Reconciliation vvvvvv

Net Sales 42,000

Less: Beginning Inventory at Retail (14,000)
Total 28,000
Multiply by FIFO Cost Ratio 78%
Total 21,840
Add back: Beginning Inventory at Cost 8,700
Cost of Goods Sold 30,540
Intermediate Accounting Part 1
 SEPARATE COST RATIOS FOR EACH
DEPARTMENT
• When applying the retail method,
separate computations should be made
for departments that experience
significantly higher or lower profit
margins. These separate computations
for each department necessitate the
consideration for departmental transfers
in and out.

Intermediate Accounting Part 1

 SEPARATE COST RATIOS FOR EACH
DEPARTMENT
• Distortions arise in the retail method when
a department sells goods with varying
margins in a proportion different from that
purchased. In which case, the cost to retail
percentage would not be representative of
the mix of goods in ending inventory. Also,
manipulations of income are possible by
planning the timing of mark-ups and mark
downs. Intermediate Accounting Part 1